While being positioned as something of a nuts-and-bolts supplier of components to the burgeoning enterprise data storage market might sound like a good thing, Xyratex (Nasdaq:XRTX) is at a very challenging point in its lifecycle. With a major customer potentially moving more and more of their business away from Xyratex, the company needs to start finding new sustainable growth markets.
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A Tough First Quarter
Xyratex didn't do much to dispel the worry that its business is facing the risk of substantial erosion in the coming years. Revenue fell 18% this quarter and missed the average sell side estimate by about 7%. In addition, revenue in the enterprise data segment fell 19%, while hard drive capital equipment sales fell 10%.
Oddly enough, the company posted surprisingly strong profit improvement. The company saw some major mix benefits in its gross margin, and this metric improved six points from last year. Management's commentary on the call didn't really support the notion that this is going to be a sustained, dependable shift, though. However, management does deserve real credit for trimming down the operating expenses and operating income more than tripled.
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The Ice Cube Is Melting...
Looking back through the history of this company, one of the bigger issues in the last couple of years has been the risk that NetApp (Nasdaq:NTAP) will move more and more of its business away from Xyratex. While NetApp has long been a major customer (40%+) for the company, NetApp has the right to source its disk enclosures elsewhere under license from Xyratex. That puts Xyratex in the unenviable position of keeping against lower-cost contract manufacturers and incurring the deadweight of lost operating leverage.
Will Hard Drive Demand Rebound?
Although the electronics industry is still feeling some of the impacts of the disastrous flooding that hit Thailand last year, the hard drive industry seems to be settling down. What's more, with recent acquisitions, Western Digitial (NYSE:WDC) and Seagate (Nasdaq:STX) are larger, and arguably more stable, companies and that should be good for a cap-ex equipment provider like Xyratex.
Unfortunately, I'm not sure it's going to work out that way. For starters, the HDD capex business is a small component of Xyratex's revenue base, dwarfed by the enterprise storage business. Second, with the oncoming rise of solid-state storage, I'm not sure the HDD business is really on any firmer ground than it was before.
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Not All Is Lost
Xyratex is not doomed at this point. For starters, it doesn't look like NetApp will (or perhaps even can) move all of its business away without warning. What's more, companies like Dell (Nasdaq:DELL) and IBM (NYSE:IBM) still source meaningful amounts from the company.
The company also is looking to develop new products and markets tied to cloud storage and high-performance computing. To that latter end, the company has a relationship with well-known supercomputer company Cray (Nasdaq:CRAY). All of that said, few companies have made much money on high-performance computing over the years and these new ventures are decidedly unproven.
The Bottom Line
With so many unknowns regarding NetApp's plans and the company's ability to create new markets, buying Xyratex feels like reaching out for a falling knife. In my book, that's a bad way to handle cutlery and a good way to get slashed up pretty badly.
Xyratex is arguably underpriced if management can limit the ongoing sales erosion and continue to drive better profitability and free cash flow. Unfortunately, the deltas on these models are huge and fair value could be anywhere from the single digits to the $20s. Investors who think they really have an edge here could definitely make some money, but this is not a stock for those with just a passing familiarity.
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At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.