Xyratex Ltd.'s (NASDAQ: XRTX) hard disk drive-related business segment Storage Infrastructure is currently under pressure from continued, weak demand and excess supply for 2.5-inch (i.e. notebook) drives, according to RBC Capital Markets.
The brokerage downgraded its rating on shares of Xyratex to sector perform from outperform and lowered its price target to $14 from $19, as the company's Stroage Infrastructure (SI) segment is currently under pressure. The brokerage suspects the stock price may come under pressure over the near term due to the elevated multiple on degrading earnings power.
In addition, we believe Western Digital's proposed acquisition of Hitachi Global Storage Technologies (HGST) will likely result in the combined entity significantly curtailing its capital expenditures as it rationalizes the existing infrastructure. In this regard, we expect a similar, negative dynamic to Xyratex's SI revenue stream as what was realized in Seagate's acquisition of Maxtor in May 2006, said Amit Daryanani, an analyst at RBC Capital.
Our rating reflects our concern that Xyratex's earnings fundamentals will show a period of material decline in FY11 (due to the Western Digital/HGST merger) and then stabilization to slight growth in FY12 (due to higher NetApp outsourcing mix to other suppliers and full exit of the EMC Data Domain contribution). In this scenario, we believe the shares may remain range bound in the low double-digits for quite some time, said Daryanani.
Daryanani said that shortly after Seagate closed its Maxtor purchase, this Xyratex customer moved to utilizing existing production test equipment held by Maxtor for the combined entity's requirements for the next 12 months.
At essentially no additional cost, this Seagate shift made financial sense and enabled the company to report acquisition cost synergies at a much faster pace than was initially detailed to investors, RBC Capital said in a note to clients.
Daryanani said that as a result of this purchasing change, Xyratex's revenue contribution from Seagate was severely impacted and was more than cut in half on a year-over-year basis after the first full quarter of combined Seagate/Maxtor operations (i.e. November 2006 quarter).
At the time of Seagate's purchase, Maxtor was in the initial process of qualifying Xyratex's production test equipment; thus, Maxtor was not a material SI revenue customer.
The brokerage lowered its 2011 adjusted EPS estimate for Xyratex to $1.50 on revenue of $1.54 billion from $2.45 on revenue of $1.64 billion, and its 2012 estimate to $1.57 on revenue of $1.55 billion from $2.70 on revenue of $1.666 billion.
Our lowered revenue and estimates are solely tied to reduced figures for the SI division. We believe Western Digital's FY10 revenue contribution was about $100 million (or about 30 percent of SI revenue) and Hitachi was minimal, as Hitachi was still in the initial qualification phase for Xyratex's production test equipment, said Daryanani.
However, Daryanani believes Xyratex factored a healthy ramp in HGST revenue in its fiscal 2011 SI revenue guidance, particularly in fiscal second half of 2011.
Mirroring the Seagate/Maxtor integration process, Daryanani believes Western Digital will rationalize the capital expenditure plans of the combined entity, with the HGST revenue ramp at Xyratex likely not occurring and Western Digital materially scaling down its spending plans.
Daryanani believes Xyratex's Networked Storage Solution (NSS) division continued to experience robust results versus expectations in the February 2011 quarter, and he expects this trend to likely continue through FY11. However, Daryanani believes this strength will not be strong enough to offset the degrading SI fundamentals.
As an ongoing reminder of the importance of SI's gross income contribution, Daryanani noted that SI accounted for only 23 percent of Xyratex's fiscal 2006-2010 total revenue but represented 39 percent of total gross income.
For FY11, Daryanani now expects SI revenue of $225 million (was $325 million), versus Xyratex's outlook of $290 million to $360 million. Daryanani said his new, fiscal 2011 estimates for the SI division reflect a 15 percent revenue mix and 30 percent gross income contribution.
Xyratex stock is trading down 5.48 percent at $12.07 on the NASDAQ Stock Market at 9:36 am EST.