SB / XRTX: L-T Story Intact, but N-T Choppiness Likely; Reducing to Hold
HOLD (2)
High Risk (H)
Mkt Cap: $590 mil.
August 23, 2006 SUMMARY
* While normally tempted to step up to the
shares off a 20% decline in the recent 2
months, we are moving to the side and
reducing our rating to Hold from Buy.
* At the heart of our concern is what
appears to be a more modest and back-end
loaded contribution from Seagate/Maxtor
vs. initial expectations. Potential
incremental oppt'ys from Hitachi and Showa
don't ramp until 2H next yr.
* Although the longer-term story is
intact, assuming no further degradation in
HDD industry fundamentals, this new
dynamic leaves November and February
expectations at risk.
* Reducing November from $250M / $0.56
(Non-GAAP) to $244 / $0.51 ($0.44 GAAP)
vs. $252/$0.57 cons.; FY07 from $1.1B /
$2.37 to $1.07B / $2.25 vs. $1.05B / $2.39
cons.; and FY08 from $1.28B / $2.68 to
$1.24B / $2.57
* Price target cut from $35 to $24, or 11x
FY07 EPS, 12x GAAP.
FUNDAMENTALS
P/E (11/06E) 9.7x
P/E (11/07E) 9.3x
TEV/EBITDA (11/06E) 6.1x
TEV/EBITDA (11/07E) 5.2x
Book Value/Share (11/06E) $7.93
Price/Book Value 2.6x
Revenue (11/06E) $968.0 mil.
Proj. Long-Term EPS Growth NA
ROE (11/06E) 33.3%
Long-Term Debt to Capital(a) 2.1%
(a) Data as of most recent quarter
SHARE DATA . RECOMMENDATION
Price (8/23/06) $20.94 Rating (Cur/Prev) 2H/1H
52-Week Range $33.20-$12.93 Target Price (Cur/Prev) $24.00/$35.00
Shares Outstanding(a) 28.2 mil. Expected Share Price Return 14.6%
Div(E) (Cur/Prev) $0.00/$0.00 Expected Dividend Yield 0.0%
Expected Total Return 14.6%
EARNINGS PER SHARE
FY ends 1Q 2Q 3Q 4Q Full Year
11/05A Actual $0.34A $0.45A $0.29A $0.54A $1.62A
11/06E Current $0.28A $0.85A $0.51E $0.51E $2.16E
Previous $0.28A $0.85A $0.53E $0.56E $2.22E
11/07E Current $0.48E $0.62E $0.52E $0.63E $2.25E
Previous $0.52E $0.65E $0.55E $0.66E $2.37E
11/08E Current NA NA NA NA $2.57E
Previous NA NA NA NA $2.68E
First Call Consensus EPS: 11/06E $2.21; 11/07E $2.39; 11/08E NA
OPINION
We are reducing our rating on XRTX shares from Buy to Hold while cutting our
price target from $35 to $24. With the stock off >20% in the last two months,
we otherwise would be tempted to be opportunistic buyers here. However, with
what appears to be an increasing likelihood of one to two quarters of reduced
visibility from the company's largest customer, Seagate, in the margin-rich SIG
segment, we see risk to near-term expectations. Pending a reset to reflect a
more modest and back-end loaded contribution from Seagate, or an offset via an
earlier than expected ramp of a new customer, we see little by way of catalyst
and, as such, prefer the sidelines. Continued evidence of moderation in disk
drive industry fundamentals (inventory, pricing) would be our trigger to take a
more negative stance.
Over the long-term, our positive thesis on Xyratex was predicatedpon an
assumption that the company would: 1) expand its customer set (systems and
infrastructure); 2) benefit disproportionately from the shift to higher
capacity drives and; 3) broaden its product offering/deepen account
penetration. Although we view each of these fundamental drivers as largely
intact over time, the degree to which they contribute over the near-term
appears increasingly uncertain.
At the heart of our concern is the company's exposure to Seagate, which
comprises 77% of SIG segment revenues (30% of total revenues) and 42% of total
gross profit. During calendar 2005, Seagate spent 20% of every capex dollar on
Xyratex gear, up from 15% in calendar year 2004. Primary products supplied to
Seagate include test/inspection, automation and, more recently, media cleaning
gear. Although optical inspection (heads) represents a future potential
opportunity for the company, we do not expect material contribution for several
quarters.
Seagate's normalized capital spending level is 8-9% of sales. Addressing the
positive cyclical trends in the HDD space beginning in 2H CY04, Seagate began
spending aggressively on increased manufacturing capacity, translating into
capital spending at 9% of sales in FY05 and 11% of sales in the just reported
FY06 (June). Assuming the mid-point of the normalized range, this initially
translated to capital spending expected to be down ~10% in FY07. However, with
the May 2006 acquisition of Maxtor, which was previously not a meaningful
Xyratex customer, we saw the opportunity for an offset as Seagate focused on
rapidly transition Maxtor production to Seagate standard processes (Xyratex
gear). Seagate further bolstered this view as the company initially guided to
$1.35B in capital spending in FY07, up 34% year-year.
However, upon closer inspection, and with the benefit of more recent public
commentary from the company, we are reassessing the magnitude, composition, and
timing with respect to this incremental capital spending as well as the
implications for Xyratex.
Figure 1: Seagate Capital Spending
Source: Company reports and Citigroup estimates.
Relative to the just reported year, Seagate spent $339M in test/assembly, $208M
in media, $381M in heads and $80M in facilities/other for a total of $1B. For
the upcoming year, the company previously provided a target allocation of capex
dollars at 28% media, 25% test/assembly, 18% heads and 30% facilities/other
(numbers rounded). While initial capex guidance given at the June analyst
meeting called for $1.35B, the more recent comments (earnings call) suggested
"up to" $1.3B. Applying this allocation to the revised capex outlook suggests
spending on Test/Assembly will be down ~5% year/year, media up 74%, heads down
40% and facilities/other up 388% for a total 29% capex growth.
Specific to Xyratex, the company's currently served opportunity within Seagate
is expected to be up 25% year-year. Within this, we observe that Xyratex is a
sole source provider to Seagate in Test/Assembly (outsourcing), which
represents the bulk of the company's SIG revenue. Within media, while the
growth profile appears attractive, media cleaning is a deep subset of this
opportunity and Xyratex is one of multiple sources. Further, with Woodlands 2
nearly fully equipped, incremental media manufacturing will need to come from
the Woodlands 3 facility, which has yet to be constructed. This suggests that
the opportunity for Xyratex at Seagate in media cleaning will likely be skewed
to the company's May and August '07 quarters. Finally, although spending in
heads is expected to be down dramatically this year versus last (due to PMR-
related efficiencies), any penetration into this segment by Xyratex is
incremental. That said, the company to date has not participated in this
market, and we have no expectations of a change in this status over the next
several quarters.
Taking the above into consideration, we view the company as likely facing, at
best, decreased visibility in the November and February '07 quarters prior the
reacceleration in the May and August (FQ2-3 '07) timeframe. As such, we are
revising our estimates throughout. For the August '06 quarter, we are
adjusting sales from $247M to $244M, and non-GAAP EPS from $0.53 to $0.51. For
the November quarter, our sales forecast has been adjusted from $250M to $244M
($252 consensus) with Non-GAAP EPS of $0.51 vs. $0.56 previously ($0.57
consensus). For the FY2007 year (November), we are adjusting our SIG revenue
forecast to a more modest 1% growth year-year, which will be skewed toward the
May and August quarters. To the degree that upside is present attributable to
new customers (Hitachi Global Storage), we expect it to be manifest after the
FQ1 (February) timeframe, most likely in the second half. As such, our prior
$1.11B revenue forecast has been adjusted to $1.07B ($1.05 consensus) with our
$2.37 EPS now $2.25 ($2.39 consensus). Lastly, we have fine-tuned our FY08
forecast from $1.29B and $2.68 to $1.24B and $2.57.
VALUATION
We employ sum of parts Non-GAAP P/E and P/Sales analysis to the company's SIG
and SNS segments. The average of the amount derived for the total of the two
segments under these two methods ($23 and $25, respectively) results in our $24
price target. Our prior price target was $35. On a rollup basis, Xyratex is
currently trading at 0.6x our next twelve-month (NTM) revenue estimate and 9x
our NTM non-GAAP earnings estimate. The difference between GAAP and non-GAAP is
related to amortization of deferred compensation and intangible assets, non-
recurring charges, discontinued operations, and associated tax effects. On a
GAAP NTM EPS basis, the shares are currently trading at 12x.
Related to the SNS business, we assign a 0.5x revenue multiple to our NTM sales
estimate of $648 million, and an 10x multiple to estimated segment NTM earnings
of $0.99. Previously, we had assigned a 0.6x sales multiple and 12x EPS
multiple. We have lowered both to reflect slower ramps of the company's non-
NetApp customers coupled with an associated lower margin profile. The
company's closest comp group, the contract manufacturers are currently trading
at a mean 0.4x NTM sales and 13x NTM EPS.
For the SIG business, we are assigning multiples of 1.0x and 11x, respectively
to NTM sales ($367M) and estimated segment EPS ($1.35). This compares to our
1.7x and 16x multiple assignments previously. We have lowered our NTM revenue
outlook for SIG given timing, magnitude and construction of the company's
largest customer's capital spending plans. Given ongoing risks related
thereto, we similarly have lowered our target multiple. Further, with the
incremental growth coming increasingly from the relatively lower margin media
cleaning operations, we are lowering our target P/E multiple. Our multiple
assignments compare to the company's closest peer group (semi test) mean at
1.7x sales and 22x earnings. The disconnect is reflective of what we view to
be a dissimilar positioning relative to the industry cycles in semiconductors
and disk drives.
RISKS
We rate Xyratex shares High Risk given the company's degree of earnings
volatility, relatively thin trading volumes and limited history as a publicly
traded company. Specific sources of risk that may impede the company from
achieving our estimates or price target include:
* Disk drive industry volatility. Fundamentals within the disk drive industry
are subject to a high degree of volatility. While near-term the market
exhibits signs of fundamental softening, the duration over which this
persists is uncertain. Should the market strengthen and accelerate into the
early part of next year, our XRTX estimates, price target, and recommendation
could prove conservative. Alternatively, should the market continue to show
signs of deterioration, the inverse would be likely.
* High sales concentration. During FY05, 78% of the company's sales were
derived from two customers. Seagate accounted for 30% of total revenue and
77% of infrastructure revenue. Network Appliance accounted for 48% of total
sales, or 79% of the systems segment revenue. At present, the company is
working with new customers including Hitachi and Show Denko which could prove
to be considerable sources of incremental revenue. To the degree that the
company is successful in ramping these programs earlier than our
expectations, our views would likely prove conservative.
* Increased competition expected in storage. Although we do not believe the
company's current relationships are at a material risk, there are a finite
set of major storage vendors that can be considered candidates for the
outsourcing of enclosures. Coupled with pre-existing relationships at many
of these potential customers, we believe that go-forward pricing will likely
play an increasingly significant role in vendor selection.
* Exchange and tax rate risks. The company is incorporated in Bermuda, with
principal executes offices in the United Kingdom and conducts operations in
the United States, Malaysia, Singapore and China. Although the majority of
the company's sales and expenses are U.S. dollar denominated, the company is
partially exposed to expenses (primarily R&D) based on the U.K. pound.
Additionally, Xyratex enjoys favorable tax treatment associated with its
Malaysian operations, the terms of which were recently extended from 2007 to
2012. Should the company experience an unanticipated change in business mix,
or there is an otherwise unforeseen change in Malaysian legislation related
to tax holidays, our tax rate assumptions could prove insufficient.
INVESTMENT THESIS
We rate the shares of Xyratex Hold/High Risk with a $24 target price. Although
the company appears positioned to capture a portion of the elevated capital
spending environment within the disk drive market, the timing, magnitude, and
construction (mix) of this spending appear less favorable than we had initially
expected. Assuming no further deterioration in HDD industry fundamentals,
valuation suggests only modest downside risk. As such, prior to a
recalibration of expectations or indications of new customer ramps, we prefer
the sidelines.
COMPANY DESCRIPTION
Formed via a management buyout from IBM in 1994, Xyratex has a history of
design expertise in the data storage and networking industries. The company
has leveraged this knowledge to address opportunities in the modular storage
subsystem enclosure and disk drive manufacturing equipment markets. Xyratex
sells its products directly to its strategic partners, including Network
Appliance, Seagate and Western Digital. Based in Havant, United Kingdom, the
company employs approximately 1,300 people in five countries. |
