Supermicro to Go Public, and Rackable Systems Show Why

Published: November 7, 2006

by Timothy Prickett Morgan

At some point, if it is skillful and lucky enough, a white-box server vendor gets big enough that it can shed that label and become just a name-brand server maker. And Supermicro Computer, a motherboard maker based in San Jose, California, that has transformed itself into a reasonably large and profitable maker of systems, is about ready to make that transition as it goes public.

One of the reasons why Supermicro is picking now to go public is that Rackable Systems, another server specialist from Silicon Valley based in nearby Milpitas, went public last summer and now has a market capitalization of over $900 million. Rackable is an innovator of energy-efficient, powerful rack-based servers that are used by some of the biggest names in the IT business, including Yahoo and Microsoft. But it is nonetheless a niche player compared to IBM, Hewlett-Packard, Dell, Sun Microsystems, and Fujitsu-Siemens, even if it will probably break $340 million in sales in calendar 2006. The fact that Rackable has that $900 million market valuation after reporting a loss in its latest quarter and that Supermicro had $302.5 million in sales in its fiscal 2006 year ended June 30, suggests that Wall Street would provide a similar or higher valuation for Supermicro--particularly since it is profitable. Which means now is a good time to let Wall Street in on the action.

Supermicro doesn't do a lot of direct sales, but distributes its server boards and raw servers to OEM partners. The company provides X86 and X64 systems based on processors from Intel and Advanced Micro Devices, including rack-mounted and blade server designs. Supermicro was founded in 1993 by Charles Liang, who is the company's president and chief executive officer. Liang created a popular motherboard in 1994 for Pentium PCs, and two years later, brought the first dual-socket Pentium server motherboard to market, and four years after that, Supermicro brought out the first quad-socket server board for Xeon MP chips. In general, Supermicro tends to be more aggressive about introducing new technologies to servers than the larger players, mainly because speed is the main competitive edge it can use against slower moving competitors.

According to the S-1 initial public offering documents filed with the U.S. Securities and Exchange Commission, the company has grown substantially from 2002 through 2006, and it has been profitable every year to a significant degree. In fiscal 2002 ended June 30--in the middle of a severe IT recession--Supermicro had sales of $89.3 million and a net profit of $2.2 million, or 18 cents a share. The following fiscal year, as the IT market started to recover and X86 servers started to be deployed in droves to replace expensive proprietary and Unix servers, sales grew by 54 percent to $137.2 million, and net income grew by 60 percent to $3.5 million. In fiscal 2004, when the server market had fully rebounded, Supermicro saw its sales grow another 22 percent to $167.1 million, and profits grew even faster, at 38 percent, to hit $4.9 million. In fiscal 2005, Supermicro was able to push sales up another 27 percent to $211.7 and profits up 46 percent to $7.1 million. The timing of the company's IPO is easy enough to fathom when you see that it closed out fiscal 2006 in June with $302.5 million in sales (up 43 percent) and with profits of $16.9 million (up 42 percent).

These are very good financial results, obviously--and are even more remarkable in the cut-throat server market. The fact that Supermicro has 3,500 products and sells them through over 400 channel partners is one of the reasons why these financials are so strong. Incidentally, not everything is perfect. In September 2006, Supermicro pleaded guilty to shipping 300 high-end motherboards to Dubai, which it knew were going to be reshipped to Iran--a violation of U.S. export controls. Supermicro had to pay a $150,000 fine, which is not that big of a deal, but giving Iran the computing capacity that might help it make nuclear weapons is a big deal. Also, Rackable sued Supermicro in September 2005, claiming Supermicro's products violate two of its patents.

For its part, Rackable is continuing to show growth and is trying to expand its portfolio of customers, but the costs of this expansion have pushed it into the red ink in the most recent quarter. While sales grew 40 percent to hit $80.5 million, substantially increased research, development, sales, and back office costs drove Rackable to have a $2.9 million operating loss. R&D expenses were up by more than a factor of 12, to $6.6 million; sales costs rose by 78 percent to $7 million, and general costs more than tripled to $6.5 million during the third quarter ended September 30. Even with all that, the company had $2.7 million in interest income off of its $195.8 million cash and investment hoard and reported a loss of $389,000.

Looking ahead, Rackable says that it expects sales of between $100 million and $110 million in the fourth quarter and will have net income of between 10 cents and 12 cents per share. Rackable booked $83.1 million in sales in the fourth quarter of 2005 and brought 32 cents a share to the bottom line. Clearly, the growth is coming at the cost of profits. The question is whether or not Wall Street will have patience for this strategy. Rackable is confident enough about 2007 to project that it will do between $475 million and $525 million in sales, and will bring between 46 cents and 58 cents a share to the bottom line, and by saying this, Rackable's managers clearly want to entice Wall Street to be patient.