|Shares Out. (in M):||28||P/E||52.0x||10.0x|
|Market Cap (in $M):||286||P/FCF||23.0x||6.0x|
|Net Debt (in $M):||-85||EBIT||5||33|
Background on the Company
Xyratex was originally a part of IBM, dating back to 1966. In 1994, XRTX was acquired via an MBO, only to come public again in 2004. The company is a leading provider of data storage technology, including modular solutions for the enterprise data storage industry and hard disk drive (HDD) capital equipment for the HDD industry. Xyratex has over 25 years of experience in research and development relating to disk drives, storage systems and manufacturing process technology.
Xyratex essentially helps OEMs with the manufacturing of hard disk drives and operates two primary segments: Network Storage Solutions and Storage Infrastructure:
1) NETWORK STORAGE SOLUTIONS (~$50mm in EBITDA)
2) STORAGE INFRASTRUCTURE (~10mm in EBITDA)
Significant Free Cash
Against its Enterprise Value of $200 million, XRTX has generated free cash flow of $230 million over the past decade and $122 million over the past five years. What is most impressive about this cash generation is that it was generated despite enormous R&D spend, some of which was largely misguided.
Just how large is the R&D spend?
R&D has been about $100-$110mm each of the past three fiscal years. Xyratex’s former CEO reportedly disclosed that R&D required to support XRTX’s core businesses was between $40-$50mm, implying $50-$60mm per year of R&D spend that was not generating any profits. $50-$60mm per year is essentially $1.50 - $2.00 of EPS for a $10 stock with $4 of net cash. TRANSLATION: XRTX IS A $6 NET STOCK SELLING FOR 3-4x EPS – but this is being obfuscated by excessive R&D spend.
Where is the incremental R&D being directed?
Management has been investing heavily in high-performance computing and cloud technologies, namely its ClustorCore product.
Catalyst for Change
In late 2012, hedge fund Baker Street Capital Management built a 23% ownership stake in XRTX and began rattling the cage of management and the Board, particularly in regards to R&D spend. This was no trivial exercise for Baker Street, as XRTX represents 50% of the fund’s AUM. In Jan/2013, Baker Street filed an amended 13D and published the following letter:
The letter requested a review of strategic alternatives to maximize shareholder value and urged board to immediately add three highly-qualified independent candidates to the board.
In April 2013, CEO Steve Barber was forced out and Board Member Ernie Sampras took over as interim CEO. Additionally, the Board awarded two Board seats to Baker Street, one immediately and the other scheduled for July 2013. Importantly, Baker’s managing member, Vadim Perelman, was named to a committee that was immediately charged with conducting strategic alternatives.
Xyratex reported second quarter results last night and held an earnings call. In addition to reporting better than expected results in its two core businesses, along with a confident forecast 12 months out, management and the Board voiced its support for the ClustorCore unit – and expects it to begin to turn a profit in the coming fiscal year.
Baker Street Capital has had a full quarter to look “under the hood” and clearly likes what it sees in terms of the new business unit, so much so that it publicly stated its support via a separate press release last night.
How I See Xyratex Shares at $10.50 per share?
Management believes it has exited trough-like margins and is seeing the final stages of a large customer that chose to insource more product (NetApp). The CFO blessed a 5.0% to 8.0% operating margin target for the “core” businesses last night, which at conservative revenue levels, implying:
EPS $1.60 - $2.50 2-4x EPS
EBITDA $75 - $105mm 2.0x – 2.7x EBITDA
FCF $50 - $80mm 3-4x FCF
This only includes the core business and does not incorporate incremental profitability from the new cloud-based business, which is apparently gaining share quickly. Baker Street’s letter to management argued for a SOP value of $14-$19 per share, conservatively without strategic premiums. I believe that Baker Street’s recent sign of support indicates that it sees not only how dirt cheap Xyratex is today, but how much FCF and growth could be in front of the company.