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Xyratex: Growth Company At Value Price?

 April 14, 2011 08:24 PM
 


Xyratex (XRTX) designs and manufactures digital storage solutions and storage process technology. The company can currently be purchased at a price not seen since 2004, when revenues were about one-third of what they are today. The company trades at a P/E of just 2.5, while sporting cash of $98 million against no debt.

The stock has fallen by 40% in just the last three months, as both the company's financial performance and its outlook have been below estimates. If the problems the business faces are short-term in nature, this is the kind of situation where value investors with a long-term view can generate strong returns.

In the early part of 2011, PC sales have been lower than expected, reducing demand for the company's products. One of Xyratex's two segments derives revenues in large part from the capex investments of storage firms, which results in heavy cyclicality (revenues in this segment can rise and fall significantly from period to period). When sales are softer than expected (as they have been so far this year), Xyratex's customers will of course be reluctant to invest in growth, resulting in quarterly revenue for Xyratex that has fallen dramatically.

Sales also fell because of component shortages resulting from the earthquake in Japan. Xyratex itself does not have operations in Japan, so there are no direct costs in that respect, but customers who can't procure core components from Japan are reluctant to purchase components from Xyratex that they can't assemble without the complementary parts from Japan.

One major owner appears to believe that the problems are short-term; the company is 12% owned by Royce and Associates, a firm focused on value investments. The company's board of directors appears to concur, as Xyratex recently authorized a buyback of $50 million. At today's stock price, this would represent more than 15% of the company's shares outstanding. Despite the buyback, management expects to finish the year with $100 million in cash, meaning management expects the company to generate another $50 million of cash from the business between now and the end of the year.

In its quest to earn more, the company also benefits from a very favourable tax environment. For this Bermuda-incorporated company domiciled in the UK with manufacturing operations in Malaysia, taxes are nowhere near US business rates. As a result, operating income has been a decent proxy for net income, allowing the company to keep more of what it earns.

Not all of the issues are short-term, however, as there are some potential problems that could hurt the company in the long run. Customer concentration is high, and continues to increase. Companies in the storage space have been consolidating, giving them greater resources to research and develop the products they currently buy from Xyratex, and the market power to lower Xyratex's margins.

Furthermore, as a player in the fast-evolving technology space, Xyratex is only as good as its newest products. There is the risk that the company will fall behind the competition as the cloud-computing world continues to evolve. Investors must ensure that they understand the competitive threats facing the company from not only continuously evolving specs, but potential disruptive technologies that can alter the competitive landscape.

Disclosure: No position
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