[Member] Xyratex (XRTX) is Still a Bargain

This is a past Premium recommendation and is made available for your reference. For more past trades, refer to our trade history.

You might recall I recently purchased shares in the data storage company Xyratex (XRTX). This is a reasonably small company (Market Cap: $300 Million) based in Havant UK that provides solutions and technologies that disk drive manufacturers and other OEMs use for their enterprise class storage systems. The company’s business can be divided in two different segments:

  • Networked Storage Solutions, and
  • Storage Infrastructure

NSS (Networked Storage Solutions): The Networked Storage Solutions segment offers storage subsystems that comprise modules, such as storage controllers and disk drive enclosures. It also provides RAID technology to protect users from failure of disk drives.

SI (Storage Infrastructure): The Storage Infrastructure segment offers hard disk drive production test equipment, media write equipment, substrate and media cleaning systems, media automation, media burnish, glide, and certify products.

Although small, the company has an excellent pedigree, having being founded in 1981 in an MBO from IBM.

Key Financial Ratios (based on closing price as of Jul 8,2011)

  • Market Capitalization: $305 M
  • Share Price: $10.05
  • Earnings (TTM): $2.2/Share
  • P/E ratio: 4.57
  • Book Value: $368.7M
  • P/B ratio: 0.83
  • Cash on the Books: $126.92 Million
  • Long Term Debt: 0

Here we have a company selling for a very low P/E, below Book Value and almost $127M in cash with zero long term debt. Also it should be noted that the current ratio is a healthy 2.43 so this is not a company that has any problems paying its bills in the short term. On the contrary, the company has been busy buying back its stock (always an indication that insiders feel strongly that their shares are undervalued) and bought back 551 thousand shares (at the cost of $5.3 million ~ basically at current market prices) in the last quarter alone. 71% of the stock is owned by institutions that include  Royce Funds (a well known value shop), Blackrock and Renaissance Technologies.

The market is only valuing the company at $305 Million.

Why is the Market Undervaluing Xyratex?

If you look at the quarterly income statement for the last 4 quarters, net income has declined from $1.19/share to a loss of $0.15/share. This is a severe decline, but easily explained. Also to be noted is that the cash on the books went from $85 Million to $127 Million, and the company had solidly positive free cash flows in each of the quarters.

The decline in the income is primarily due to a 67% decrease in SI revenues that reduced the company’s SI margins from 34.6% a year ago to –2.7% in the current quarter. This decline fortunately is not due to any company specific issue but a general industry reduction in demand as the customers wait for regulatory review of some of the consolidations in this sector (Hitachi and WDC merger).

Catalysts for the Stock Going Forward

The company believes that the 2nd half of the year will see a turnaround with return to profitability. As the regulatory concerns ease and the demand picks up, expect the company to regain its margins in the SI segment. The company has also reduced fixed costs during the last several months so the profitability should improve as the business conditions improve.

With over $4/share in cash, it is also very tempting for the company to distribute part of it as dividends to the shareholders. Since the company does not have any long term debt and has a healthy current ratio, it does not require this large amount of cash to operate. If the company does announce a dividend one can expect renewed interest and attention to the stock.

Final Word: While it is common to calculate the P/E ratio as share price/Earnings per share or alternatively Market Capitalization/Net Income, it is more accurate for valuation purposes to remove the cash from the market capitalization (except for the amount necessary for a healthy level of working capital) assuming the company will distribute the cash and calculate an adjusted P/E ratio. On that basis, XRTX currently trades at P/E ratio below 3 based on last twelve months of earnings. One can expect the earnings to be down in the next quarter compared to the year ago. The company expects 0.01 to 0.19 per share compared to $1.19/share a year ago. This will increase the adjusted P/E ratio to almost 6, which is still low and if as expected the SI segment starts showing signs of improvement, the stock price will move up to a much more reasonable valuation.

At this time I am and will be a buyer of the stock at any price below $12/share. This provides a sufficient amount of margin of safety. A more reasonable valuation puts the stock at an adjusted P/E of 10 (share price = $16.6) next quarter which implies about 40% discount is available today

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