Some initial thoughts on Xyratex, an apparent bargain.

Xyratex is mainly an enterprise storage solutions supplier (to NetApp, EMC, Dell, Hewlett Packard, IBM…) and to a much smaller extent an equipment supplier to the hard drive manufacturers (Seagate and Western Digital)

When I found about it last week it was trading at a bit over 8 (it just went up 11% to 9.28 today !)

Here are some points that drew my attention :

- Almost 4 cash/share
- No debt
- Cyclical business
- Just paid 2 dollars per share in dividends
- Fixed 4% cash dividends
- Cash flows not bad at all
- Just last year it returned 25% of its market cap in dividends
- It had recently around 50% of its market capitalization in cash. Now that the stock run up a bit it is lower.
- It also bought almost 10% of its shares since the end of 2010. For example in 2011 it bought 3.6 million shares for 32.6 millions , that’s just 8.97 per share, very close to the year low, in 2012 they also bought smaller amounts on the low side of the year, I would not be surprised if they keep buying at current levels.
- The company originally was a spin off from IBM (and makes sure that it’s known).

It’s a small cap, mainly an unknown company. No problem with that, even better.

I came to know it thanks to Western Digital, one of their clients and at the same time suppliers.

I decided to study it more to expand my circle of knowledge and who knows maybe buy… I thought it could make for a nice acquisition target.

One thing worth noting is that their share price was cut in half in 2012, it has been trading at low levels in comparison to it’s tangible assets but its earnings have been very volatile. In 2004 it lost $120 million, after a look at their annual report that year I saw it was mainly due to non cash charges related to their IPO that forced them to record under GAAP equity compensation expenses of $168.1 million.

After the superficial initial look at the numbers and year reports I read during the weekend 10Ks from companies that are supplied directly by hard disk drive manufacturers, specifically NetApp, EMC, XRTX and VMWare. All of them are pure play storage solutions suppliers. One of the biggest cost (or the biggest) of those companies are HDD drives. I know a about that sector because Western Digital has been in my portfolio several times (including a moderate position now).

I have a hard time to see how sustainable pure play storage supplier companies are. They rely on hard drives which become costlier due to the consolidation of their manufacturers (just 3 are left and 2 have 90% of the market). Even several of their customers are selling good storage solutions made by themselves with added functionality: several companies such as Dell, Cisco, Hewlett are offering unified solutions to storage which include networking and server. It’s an area that is doing pretty well.

So even though EMC has done OK up until 2011, I do not see clearly what will happen to those companies from here on, I have an even bigger doubt with Xyratex due to their much smaller size.

That said I keep studying it since as a Western Digital, Cisco and Dell investor it is essential that I understand the economics of the HDD customers and OEMs and who knows if maybe one day I buy one of them.

Xyratex (XRTX) could seem cheap in the Walter Schloss / Benjamin Graham sense. But it worries me that Dell (another company I own) and NetApp are already dropping XRTX as they simply build their own storage solutions directly buying to HDD manufacturers. Dell even dropped EMC which is a gigantic company compared to XRTX. Dell now makes their own storage boxes along with networking, all are directly build in their blade servers. Even Cisco, which I also own, has a very good integrated solution that includes storage, server and networking. Even the troubled Hewlett Packard is providing a unified solution and eating into the supply chain provided by Xyratex, EMC+VMWare and NetApp.

XRTX is not an HDD manufacturer as might be believed but an assembler and provider of storage solutions. Quite a few companies are positioned to do that and bypass XRTX altogether. I do not see strong barriers of entry to their business.

The long term position of Xyratex is not clear and could even be destroy value. Then again it also could be bought out. That’s maybe why the price went up when there was so much M&A activity going on with storage solution providers a few semesters ago. Xyratex is undeniably a good cash generator until now but from what I know it feels too much of a gamble. Just imagine what would happen if NetApp, their biggest customer, is successful at making the solutions provided by XRTX ? It would simply drop them as a supplier and buy directly from the HDD makers. Actually NetApp has been dropping them already since the last 2 years. That is mentioned by Xyratex in their SEC fillings and conference calls and reflected on their financial results.

My point is that I do not like the place where they stand at in the supply chain. They are under bigger storage suppliers such as EMC and NetApp, Dell, HPQ and Cisco but above HDD manufacturers such as Seagate and Western Digital. The risk I see is that they get squeezed out.

They could save themselves by being bought out but even the CEO in a conference call said no one is interested in them so that is not a bet I would like to take. They could make top products and grow their business, but that also does not seem clear to me. Their R&D spending is high and has produced no earnings. On the contrary it is burning most of them. In other words, I cannot see clear their competitive advantages or how sustainable they are. That said I might have made a nice 11% in a day if I had bought it last Friday, but given what I now know it would have felt too much of a gamble and as such I would have probably sold it out by now.

It is interesting to see what Xyratex’s largest shareholder declared today by reading the following letter delivered to the board of directors and available as a SEC filling.

In that letter Baker Street Capital Management LLC has declared on Monday that Xyratex Ltd. (NASDAQ:XRTX) should reflect strategic alternates, noting that the firm’s present market price is intensely lesser than its intrinsic value.

It states that the company is deeply undervalued due to excessive R&D spending and flawed strategic direction, calls for a fair and thorough review of strategic alternatives to maximize shareholder value, urges board to immediately add three highly-qualified independent candidates that it believes should be immediately added to the Board. Baker Street concluded that it hopes to work constructively with the Board and management to explore ways to unlock value at Xyratex for the benefit of all shareholders.

Baker, which owns about 23 percent of Xyratex’s shares declared the firm’s valuation inconsistency is mainly due to the flawed strategy of investing substantial profits from the firm’s mature core businesses in loss-making and unverified HPC (High-Performance Computing) and Cloud initiatives.

Baker stated that Xyratex is infected by excessive and unnecessary research and growth spending on speculative non-core initiatives that have unsuccessful to generate optimistic returns and have cruelly hurt the firm’s profitability.

Here are some interesting extracts from the letter:

Instead of focusing on creating value for the benefit of all stockholders, this Board has chosen the short-sighted approach of stalling, defending its flawed strategy, and offering excuses for why it is not able to have substantive discussions with us, including making troubling statements that “it’s not a priority for [them].” This reinforces our view that Xyratex’ Board is in critical and urgent need of new directors with a fresh perspective who will be dedicated to unlocking the significant upside embedded in Xyratex shares. We believe the Board should immediately appoint three new directors we have identified, who are committed to working with the Board to rigorously re-examine the current capital allocation and R&D strategy, aggressively focus on maximizing profitability, and engage a reputable investment bank to explore strategic alternatives.
…..
When Baker Street began to aggressively acquire Xyratex shares in early October, the stock price implied a market value that represented just 55% of Tangible Book Value and a discount of over 37% to the Company’s Net Current Asset Value (used by many investors as a proxy for a company’s liquidation value). Adjusted for cash and net receivables, the market ascribed almost no value to the Company’s operating business, its inventory, or its intellectual property.

DESPITE LARGE LOSSES FROM NON-CORE GROWTH INITIATIVES XYRATEX HAS VALUABLE CORE ASSETS PRODUCING SIGNIFICANT PROFITS AND FREE CASH FLOWS
….
Xyratex is expected to have $90 million of net cash at the end of the current quarter. This implies that at the January 12, 2013 closing price of $8.37 per share, Xyratex is currently trading at an adjusted enterprise value of only $137 million. As shown in the table below, we believe that this represents only 2.2x the EBITDA produced by its market leading core business segments. Xyratex also trades at discounts to its Tangible Book Value per share of $10.29 and even its Net Current Asset Value of $8.81 per share, a valuation that implies the Company is worth less as a going concern than its net current assets, despite the significant value of its businesses and the $470 million spent on R&D in the past five years.
….
We were disappointed that the Board very recently failed to capitalize on a highly accretive opportunity to repurchase a significant amount of Xyratex stock at a deep discount to Tangible Book Value, and an even deeper discount to intrinsic value. A Board member explicitly told us that the Board decided to forgo this attractive transaction to avoid increasing Baker Street’s percentage ownership in the Company. This decision was made even after we had clearly communicated our willingness to limit our voting rights if it would allow the Company to proceed with this value-enhancing transaction. Instead, the Board declared a special dividend returning only 37% of the current quarter’s projected net cash to keep shareholders at bay and put in place a “poison pill” shareholder rights plan to entrench itself and buy more time for its flawed R&D strategy.
….
As the largest shareholder of Xyratex, our interests and incentives are directly aligned with those of all shareholders. We are deeply cognizant of our right and responsibility to step in where we feel shareholder value is at risk. Accordingly, we once again request that the Board immediately appoint our three highly-qualified candidates who will provide immediate and fresh perspective and represent the interests of all shareholders in the boardroom. Our relentless focus remains on ensuring that necessary steps are taken to build and maximize shareholder value. The first and indispensable step is vesting the power to govern the Company in a Board that has the confidence and support of the true owners of Xyratex.

Rather than stalling and continuing to make excuses, we urge the Board to immediately engage with us and look forward to a constructive dialogue to reconstitute the Board.

As implied by that letter some activism might be needed to unlock it’s value and push up the stock price. That possibility alone might explain today’s stock price increase.

The positive thing is that studying Xyratex and its eco-system reaffirmed my faith on hard drive manufacturers, specifically Western Digital (WDC), and on diversified IT suppliers such as Dell (up 15% now due to buy out talks). I like better their position in the supply chain. I just realized that Robert Rodriguez one of the few investors I sometimes look at now has WDC as it’s number one holding. And Lou Simpson, another investor I like, might be happier today with his Dell stocks.

Cheers!
jrv

About jrv

I was born in Spain and lived in Belgium, Chile, France, USA, Argentina among other places. Currently I am trying to settle down in a wild place. I am "retired", even though now I dedicate more hours "working" for my investments than I ever worked in the real labor market where I used to work in IT and Banking. I am a family man, I have a lovely wife, several sons and one step daughter. I have humble tastes, I like to stay home and read about companies and investments. I started investing at 25 before the internet bubble exploded. I did not know much about investing and liked technical analysis so my results were pretty bad. Fortunately I did not have much to lose. Some years later in 2006 bored of doing only real state investments and with quite a lot of money saved I opened an account in a cheap and excellent online broker and started again. This time I did not want to commit the same mistake, so I decided to follow a model. I heard that Warren Buffett was the best at making money via stocks so I started by reading a lot about him, all of his shareholders letters and several of the books that he recommended. I learned a lot, started applying his investing principles and reading a lot of 10K's. Digested news from lots of different sources. Basically I started buying very good and cheap companies and holding them for ever if possible and if nothing changed fundamentally. When the housing crisis started I was more than 75% cash. At that time I identified good companies at incredibly cheap prices so I invested most of my savings in stocks. In less than I year I doubled. By the second semester of 2009 I turned my software company into an investment vehicle and dedicated myself full time to it. My wife and I decided to change our lifestyle and moved from Belgium to the beach in a wild country. The goal was to keep fixed costs low in order to be able to live with a minimum 6-8% yearly return but specially to move away from the inhuman life of civilization and to have finally some peace and sunny weather to concentrate better on investing. Now I can think and study about companies 60 hours a week and I am doing great. I can finally do what I want full time and can proudly say that I have never been so happy, specially also with my just born 4th son, my other great kids and my sweet wife who supports me fully while I study most of the day and patiently wait for the opportunity to make a swing ! You can learn a bit more about my portfolio by viewing it at www.kuchita.com/view/sumo.php or you may learn more about me and my family by following the link "Author's site" from the menu above.
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4 Responses to Some initial thoughts on Xyratex, an apparent bargain.

  1. pablo says:

    Hola jrv:

    Al enterarme de la noticia de Dell leyendo la prensa económica me he acordado de ti. Debí hacerte caso, enhorabuena, me alegro por ti.

    Despues de leer tu post compré caf va genial, estoy muy contento gracias.

    También he comprado santander y bbva, aunque creo que venderé pronto porque sospecho un reajuste del mercado, se que tu eres más de ponerte largo y no especular pero a mi me da mucha rabia perder lo ganado y creo que los recortes están al acecho en febrero.

    Me planteo comprar enagas, es una empresa que he intentado estudiar siguiendo tus técnicas y que me parece bastante buena y solvente, esta participada por el gobierno español y por Oman, se dedica a almacenar gas y me da buena impresión, no se si tu sabes algo más de ella. Otra que me gusta mucho es inditex, aunque la veo muy sobre comprada.

    Bueno, lo dicho enhorabuena y gracias.

  2. jrv says:

    Hola ! Inditex me gusta mucho, la he estudiado un poco en el pasado (2010 creo). La empresa parece super bien administrada y el gerente genial. Pero nunca me decido comprarla por el precio de la accion. Aunque en realidad si la hubiera comprado hace un par de anos hubiera sido muy bueno.

    Enagas no la conozco pero por lo que me cuentas me parece interesante eso del almacenaje de gas.

  3. georgi says:

    Not my words. Just put it for discussion on the board I like to lurk. And below is the reply of the person I like the most.
    Just for your consideration. I had no time to read about the company.

    Some things to consider re: XRTX

    1) In our 2011 fiscal year, sales to our top six customers accounted for 93% of our revenues with sales to
    NetApp Inc., Dell Inc. and IBM accounting for 42%, 22% and 13% of our revenues respectively.

    They will only do as well as these customers.

    2) Further consolidation in the industry will lead to reduced demand for XRTX products and/or will be difficult for XRTX to maintain their current margins.

    3) NetApp (the largest customer) going forward will use contract manufacturers, under license, as an alternative source for their products. They probably will receive a royalty but this is a huge customer (reflects 42% of their revenue). Therefore, w/ only three customers that represent 77% of revenues is a big risk looking forward.

    Based on XRTX forward PE of 69 (trailing PE is 16), buying shares of their customers may be a better bargain. Seagate Technology Public Limited Company (STX) or Western Digital Corporation (WDC) might be better value plays with their low PE’s (both under 5).

    I prefer the “cloud computing” sector more than the hardware manufactures. XRTYX may have been a good play before the cloud but now there are better plays in the cloud IMO.

    EKS

  4. jrv says:

    Hi Georgi thanks! Those are important risk factors disclosed in their 10K. NetApp is each time more doing their own thing, they need Xyratex less and less.

    I like Western Digital, much better.

    Cheers !
    jrv

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