Rackable Shelved for Now

Rackable Systems, Inc. (RACK) continues to lead in green technologies for lower power consumption, high-density servers. RACK reported disappointing Q2 results, which it blamed on a onetime discount to win a new customer and component shortages.

Although second quarter results were a setback of the progress RACK has made over the past year, we believe it is still on track for improvement. Rackable had suffered from aggressive price competition in the past.  Mark Barrenechea, the company’s new CEO, is focused on maintaining its competitive advantage in the form of power efficient and leading-edge technologies, which it had drifted away from.

The company currently has nine active customers out of the top 20 Internet sites in the United States, with Yahoo (YHOO - Analyst Report), Amazon (AMZN - Analyst Report), Microsoft (MSFT - Analyst Report), YouTube (GOOG - Analyst Report) and Facebook its top four customers. We believe there are numerous opportunities in other verticals, such as financial services and other data intensive operations, which have been growing rapidly. To drive sales of its products into verticals where it is not already strong, RACK plans to work with select resellers and recently entered the Japanese market through distributor CTC.

With the market for power efficient computing coming to the forefront, RACK could be an acquisition target for a larger company looking to advance its capabilities should the valuation remain depressed. We therefore maintain a Hold rating on RACK shares and lower our price target to $11.00, which is based on a P/S multiple of 0.9x 2008 revenue.

Rackable Systems currently trades at 0.9x our 2008 revenue estimate, a discount to the industry mean. We do not expect the company to return to GAAP profitability in the near future, and neither do we believe that the company will return to previous margins given the increasingly intense competitive environment and the need for RACK to invest in engineering.

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