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Rackable's margins enter witness protection program

Rivals hold MS, Yahoo, Amazon and Q1 profits hostage

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Rackable Systems' start-up glory days have officially ended courtesy of some shockable first quarter results.

The little server maker that could - didn't. Rackable's first quarter revenue tumbled 15 per cent year-on-year to $72m.

The company also swapped out last year's $6m profit for a $10m loss. And, in the most ominous sign of all, Rackable's gross margin fell to - prepare your magnifying glass - 13.5 per cent from 24 per cent.

In a brutally ironic, some say inevitable, twist, Rackable's demise has been caused by the very things that turned it into a hardware superstar - Microsoft, Yahoo! and Amazon.

Rackable has pumped these three accounts for all their worth and for the vast majority of its business. Apparently, Dell, HP, IBM and Sun Microsystems finally caught on to this fact.

"The key factor affecting our performance during the quarter was aggressive pricing from competitors for orders at our top three accounts," said Rackable CEO Tom Barton.

But there's hope.

Rackable will craft three, enormous service providers in its R&D lab, which are incapable of buying servers from rivals.

Oh, wait. We made that up.

"We are encouraged by the progress we've made over the past thirty days in assessing our long-term business model," Barton explained, in reality. "These steps include a newly-defined plan for handling business at our largest accounts, a strategy for diversifying our sources of revenue, and a focus on higher gross margin products. We believe we have the right team and strategy in place to stabilize gross margin attainment and improve long-term profitability."

Some of you will recall that Rackable has been trying to diversify its business for a long time now. And we're skeptical how it can handle business with its three largest accounts any better if rivals are prepared to give away their gear, as seems to be the case.

On the management front, Rackable has tapped Gautham Sastri, the founder and CEO of Terrascale, a company acquired by Rackable last year, as COO. Current president Tom Ford will turn into an EVP before leaving the company at the end of 2007, while Barton will regain the president title.

It's quite easy to argue that Rackable is a one trick pony with a murky future ahead of it. The company, however, knows this as well as anyone and has been working to grow higher margin storage sales and to craft unique products such as its data center in a container - Concentro. In addition, Rackable has long made low power consumption and compact servers priorities that helped it compete against the big boys.

As so often happens, the Tier 1s have wised to Rackable's strategy over time and built out very similar gear. And now they've dropped a Texas-sized bowling ball on top of Rackable's margins.

After hours, Rackable's shares sank to a 52-week low of $12. That's the lowest per share price since Rackable IPOed in mid-2005 and so very far off its 52-week high of $53.24.

Who said the server business is tough? ®

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