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.
Investopedia Broker Guides: Enhance your trading with the tools from today's top online brokers.
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.
SEE: Understanding The Income Statement
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.
SEE: Analyzing An Acquisition Announcement
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.
SEE: 5 Must-Have Metrics For Value Investors
Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.
Stock AnalysisA summary of what Allstate Insurance sells and whom it sells it to including recent mergers and acquisitions that have helped boost its bottom line.
Options & FuturesInvesting during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
Investing BasicsHeld onto a stock for too long? Selling at a loss is never ideal, but it is possible to minimize the damage. Here's how.
EconomicsWill remaining calm and staying long present significant risks to your investment health?
Stock AnalysisIs DKS a bargain here?
Investing NewsA third of Americans use an AT&T mobile phone. How did it evolve from a state-sponsored monopoly, though antitrust and a technological revolution?
Stock AnalysisHome Depot has outperformed the market by a wide margin in the last 12 months. Is this sustainable?
Stock AnalysisYelp investors have had reason to be happy recently. Will the good spirits last?
Stock AnalysisWalmart is enjoying a short-term rally. Is it sustainable? Is Amazon still a better bet?
Stock AnalysisAs a company that primarily sells discretionary products, GoPro and its potential falls right in line with consumer trends. Is that good or bad?
When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>