Skip to main content

Editor's note: This alert was originally sent to subscribers of Breakout Stocks on April 28 at 11:25 a.m. EDT and is being republished as a bonus for readers. For more information on this newsletter, click here.

Rackable Systems


reported first-quarter earnings that were dramatically better than expected after the close Thursday, and we want to provide readers with an update. We are not taking action in this alert.

For the first quarter, Rackable posted earnings of 30 cents a share on $84.4 million in revenue, trouncing the consensus analyst estimate of 19 cents a share and $71 million. The company's results were also well ahead of previously established guidance of earnings of 17 cents to 20 cents a share on revenue of $68 million to $72 million. In addition, Rackable's balance sheet is in excellent shape, with $208 million, or $7.93 per share, in cash, based on average diluted shares outstanding in the quarter.

Strength in the quarter can largely be attributed to the continued aggressive capital expenditure buildouts by key customers









, which accounted for 77% of revenue in the quarter, up from 72% in the fourth quarter. Gross margins were 23.9%, a bit lighter than we hoped for, as higher-margin storage business represented only about 7% of revenue, down from 9% in the fourth quarter.

The stock initially reacted well to the report, trading as high as $52.50 after hours, and was recently trading at $50.22, up 3.3%.

For those new to the story, Rackable makes servers and storage equipment with a focus on designs that minimize heat generation and energy use, which can lower the operating costs of data center and network operators. The company receives the majority of its revenue from customers in the Internet space and has been a beneficiary of strong capex spending by these companies.

Rackable gave strong second-quarter guidance of earnings of 21 cents to 23 cents a share on revenue of $80 million to $85 million, well ahead of prior analyst expectations for earnings of 19 cents a share on revenue of $73 million. Full-year earnings guidance is now at 84 cents to 88 cents a share on $325 million to $335 million in revenue, beating the Wall Street consensus forecast for earnings of 83 cents a share on $305 million in revenue. These numbers are also well ahead of the guidance Rackable gave on its fourth-quarter conference call in February, which called for full-year earnings of 76 cents to 80 cents a share on $285 million to $300 million in revenue.

Rackable's guidance is impressive at a glance, but after crunching the numbers, we believe it may actually be conservative. If we take the midpoint of the company's new full-year revenue guidance ($330 million) and subtract the first quarter's results ($84.4 million) and the midpoint of the company's second-quarter guidance ($82.5 million), the company is guiding for a total of $163.1 million for the third and fourth quarters combined.

In the third and fourth quarters of 2005, Rackable had a total of $140.5 million in revenue, implying that Rackable is guiding for year-over-year revenue growth of just 16% in the second half of the year. We believe that Rackable can achieve year-over-year revenue growth of 40% -- which is in the range of Wall Street forecasts and consistent with how revenue has been tracking -- in the back half of 2006, implying total full-year revenue of $364 million, which would be 10% above current guidance.

If we do the same exercise with the company's earnings guidance, Rackable is essentially guiding for 34 cents a share for the second half of the year. If Rackable is guiding for $163.1 million in revenue for the second half and we assume an 11.5% operating margin, $3 million in interest income, a 41% tax rate and 30 million diluted shares outstanding based on forecasts by Wall Street analysts and the company's stated guidance, we calculate earnings of 43 cents a share -- 9 cents above what the company's current earnings guidance implies -- for the back half of the year.

This figure would imply full-year earnings of 95 cents a share, which would be 10% above the midpoint of current full-year earnings guidance. And of course, that 95 cents-a-share number implies that the company reports a merely in-line second-quarter earnings report. So, we believe Rackable is continuing its practice of underpromising.

Using the same assumptions, but with our optimistic case of $197 million in revenue (40% year-over-year revenue growth) for the second half of the year, we calculate earnings of 50 cents a share for the next two quarters combined. This would imply full-year earnings of $1.02 a share, which would be 19% above the midpoint of current full-year earnings guidance.

Nonetheless, we believe that Rackable's earnings guidance could have been a bit better, given that it raised full-year revenue guidance by 13%, but raised earnings guidance by only 10%. But that is likely the effect of the increase in diluted shares outstanding from the company's recent secondary offering. In addition, the new full-year earnings guidance was only slightly ahead of the consensus estimate of 83 cents a share, but as we show above, the company's earnings guidance is likely on the conservative side.

As we mentioned above, Rackable's balance sheet remains strong with $208 million in cash and no debt. The company's inventories rose 48% sequentially to $60 million, which some may take as a bearish sign. Rising inventories are sometimes a concern as it may imply a company has a large stock of goods it needs to sell, often at lower prices. However, in Rackable's case, it is actually a bullish sign because the company builds a great deal of its servers and storage products as orders come in, so that inventory is composed largely of orders already placed by Rackable's customers.

Going forward, we hope to see Rackable improve its margins by ramping up storage revenue, which was hampered a bit this quarter due to a transition to new storage products, and management commented that it is adding new people to its storage team. Management also noted that it is targeting the financial services and government sectors for additional growth in 2006. This is a vital issue, as we would like to see the company become less dependent upon Microsoft, Yahoo! and Amazon.

Although we can't complain about the company's impressive sales performance in the first quarter, we would have liked to see the dependence upon these three companies go down, not up. Nonetheless, it is indeed a "high-quality problem."

We still believe the outlook for capex spending by Internet companies will stay strong this year, and Rackable remains the purest play on this trend.



is spending aggressively to update its products and services, and we believe Rackable's customers will have to match that spending to keep up.

However, we are leaving Rackable at a Two rating, because the stock appears to have already discounted the fact that the company is likely to continue beating estimates. It is no secret that Rackable is conservative in its forecasts, and we believe the bar is quietly being set higher by institutional investors. Therefore, we are not eager to add to our position unless the stock falls to the $40 to $44 range.

The TSC Breakout Stocks Team is Michael Comeau and William Gabrielski, research analysts at In keeping with TSC's editorial policy, they don't own or short individual stocks. They also don't invest in hedge funds or other private investment partnerships. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. For more information about Breakout Stocks, please

click here.