Xyratex Largest Shareholder Pushes UK Firm to Review Strategic Alternatives

Baker Street Capital Management, LLC (together with its affiliates, Baker Street), the largest shareholder of Xyratex Ltd with ownership of approximately 23% of the company’s outstanding common shares, delivered a letter to the Board of Directors of the company.

In the letter, Baker Street stated its belief that Xyratex’ current market price is dramatically lower than the company’s intrinsic value. It believes this valuation discrepancy is largely due to the flawed strategy of reinvesting substantial profits from the company’s mature core businesses in loss-making and unproven HPC and cloud initiatives. Baker Street stressed that a fair and thorough review of all strategic alternatives available to the company should be undertaken by a significantly reconfigured Board to maximize shareholder value. The letter highlighted the need for urgent Board change and stated that Baker Street has identified three highly-qualified independent candidates that it believes should be immediately added to the Board. Baker Street concluded that it hopes to work constructively with the Board and management to explore ways to unlock value at Xyratex for the benefit of all shareholders.

Full text of the letter:

January 14, 2012
The Board of Directors, Xyratex Ltd

Dear Members of the Board,

Instead of focusing on creating value for the benefit of all stockholders, this Board has chosen the short-sighted approach of stalling, defending its flawed strategy, and offering excuses for why it is not able to have substantive discussions with us, including making troubling statements that "it’s not a priority for [them]." This reinforces our view that Xyratex’ Board is in critical and urgent need of new directors with a fresh perspective who will be dedicated to unlocking the significant upside embedded in Xyratex shares. We believe the Board should immediately appoint three new directors we have identified, who are committed to working with the Board to rigorously re-examine the current capital allocation and R&D strategy, aggressively focus on maximizing profitability, and engage a reputable investment bank to explore strategic alternatives.

                     
Share Price Performance

When Baker Street began to aggressively acquire Xyratex shares in early October, the stock price implied a market value that represented just 55% of Tangible Book Value and a discount of over 37% to the company’s Net Current Asset Value (used by many investors as a proxy for a company’s liquidation value). Adjusted for cash and net receivables, the market ascribed almost no value to the company’s operating business, its inventory, or its intellectual property.

DESPITE LARGE LOSSES FROM NON-CORE
GROWTH INITIATIVES XYRATEX
HAS VALUABLE CORE ASSETS
PRODUCING SIGNIFICANT PROFITS AND FREE CASH FLOWS

Market Valuation of Xyratex in $ million

• Market Capitalization: $227
• 
  Quarter End Projected Cash: (90)
• 
  Adjusted Enterprise Value: $137
• 
  Core Business Estimated EBITDA (After Corporate Costs): $62
• 
  Core Business EBITDA Multiple: 2.2x
• 
  Tangible Book Value (TBV): $279
• 
  Net Current Asset Value (NCAV): 239

The market is clearly pricing in continued poor capital allocation and erosion of value through massive R&D investments. Steve Barber , the company’s CEO, indicated in our November 2012 meeting that the R&D required to fully support Xyratex’ core business is between $40 to $50 million, and Xyratex "would generate a huge amount of cash" if the company did not invest in these non-core HPC and Cloud initiatives. In the context of the $104 million spent on R&D during the last twelve months – an amount almost equal to the adjusted enterprise value of the entire business-and Mr. Barber’s estimate of maintenance R&D it is clear that the company’s current strategy is to reinvest the substantial profits from its mature core businesses in loss-making and unproven investments in HPC and Cloud initiatives with little chance of generating the returns that such risky investments require. In our view, the decision to sink $60 million (over $2 per share) a year into non-core R&D investments rather than maximize the value of the company’s profitable core business is fraught with tremendous risk for shareholders.

HPC/Cloud Guidance

• Revenue (Midpoint of management’s $60-100m guidance – Q4 2012 Earnings Call, Jan 10, 2013): $80
• 
  Gross Margin: 16
• 
  OpEx (Over 30% of OpEx (Richard Pearce – Q4 2012 Earnings Call, Jan 10, 2013)): (56)
• 
  Operating Profit of Non-Core: ($40)
• 
  2013E Consolidated EBIT: $1

• Implied EBIT of NSS & SI (Including Corp Costs): $41
• 
  Depreciation and Amortization: 21
• 
  Implied EBITDA of NSS and SI: $62

• Estimated NSS EBITDA (After Corp Costs): $52
• 
  Estimated SI EBITDA (After Corp Costs): 10

• Estimated NSS 2013 Cash Flow (Includes Working Capital Release): $101   

The company has been substantially more profitable in the past and there is no reason in our view why, if properly run, Xyratex cannot achieve significant profitability. In 2005 Xyratex generated $144 million of gross profit on $680 million in sales and earned adjusted operating income of $48 million. Needham & company estimates that in 2013 Xyratex will generate $168 million of gross profit on $900 million in sales but will earn only $1 million of operating income. The $47 million decline in operating income, despite a $24 million increase in gross profits, is attributable to the $45 million increase in R&D expenses and $25 million increase in SG&A expenses. Consistent with management comments, our research supports the view that Xyratex has a bloated cost structure which, if addressed urgently and decisively, would create an opportunity to dramatically improve profits and generate significant value for shareholders.

  
Evolution of Costs and Profitability in $ Million

(1) Needham & company 2013 Estimates
       
After a thorough analysis of the company’s segments, we believe that the current market price of Xyratex fails to reflect our conservative estimate of the value of Xyratex’ parts. As shown in the table below, we believe that if excessive R&D and SG&A spending are addressed, the company’s fair value lies between ~$13.88 and $19.61 per share, representing upside of 66% to 134%, respectively, from the current stock price. The low end of our range assumes zero value for the intellectual property and only $25 million for existing HPC/Cloud revenues, assumptions which we believe to be extremely conservative.

Sum-of-the-Parts Valuation of Xyratex in $ Million:
Valuation Range

• 
  Network Storage Solutions: 210/270
• 
  Storage Infrastructure: 50/70
• 
  Cash: 90/90
• 
  Intellectual Property: 0/50
• 
  HPC/Cloud: 25/50
• 
  Value: 375/530
• 
  Per Share: $13.88/$19.61
• 
  Upside from Current Stock Price: 66%/134%

We believe that management has failed to adequately handle the core operational issues facing the business. As a result, Xyratex must make meaningful operational improvements in order to enhance value for all shareholders. Among other things, management has to focus immediately on boosting employee morale by inspiring a customer-centric culture of high productivity, cost leadership and efficient innovation. We look forward to communicating with the Board about these and other operational concerns.

Fortunately, despite the actions of the management team and the Board that have damaged value and eroded confidence in Xyratex, we continue to believe that, given the very large disconnect between the market value of Xyratex stock and our conservative estimate of the company’s intrinsic value, opportunities exist within the control of the Board to unlock significant shareholder value. The company’s core profitability, solid reputation in storage hardware, established long-term relationships and intellectual property make it an attractive asset both strategically and financially. Our concern, however, is that the Board as currently composed is uninterested or unwilling to pursue the most value-maximizing path for shareholders. We believe that a thorough review of strategic options and value-maximizing opportunities should be promptly undertaken to weigh against the company spending even more of the shareholders’ capital on speculative R&D research. This review should be led by a reconfigured Board which includes significant shareholder representation. Among other things, we are troubled by statements made to us by Mr. Barber in our November 15, 2012 meeting that the Board "has not historically been focused on the per-share intrinsic value metric." This reinforces our conviction that a fresh perspective is needed in the boardroom to introduce an owner mentality and focus management’s efforts on enhancing per-share value for all shareholders.

Additionally, the presence of the two top executives on the Board interferes with its responsibilities to hold management accountable. Glass Lewis & Co., a leading proxy advisory firm, has taken issue with the CFO Richard Pearce’s position on the Board, noting: "We believe that the unique financial information and control over the company’s finances that is typical for a CFO should place the CFO in the position of reporting to and not serving on the board. It is crucial for the board to be in the position of overseeing the company’s finances and its reporting. This oversight is likely to be more complicated and less rigorous when the CFO sits on the same board to which he reports." We fully agree. The ultimate job of the Board is to protect shareholder interests and ensure that management acts in a manner that maximizes shareholder value. The inevitable conflict of interest resulting from the service of Xyratex’ CFO on the Board comes at the expense of shareholders, who have vested in this Board the responsibility to watch over their investment.

As you know, I met with Board members Steve Sanghi and Ernest Sampias on December 11, 2012 in an attempt to engage in constructive, amicable dialogue regarding value enhancing opportunities for the company. At the meeting, I suggested that three new highly-qualified individuals be added to the Board. Since that meeting we believe that management and the Board have consistently chosen to implement roadblocks to avoid engaging in productive communications with us. As you are aware, we believe that immediate shareholder representation on the Board would be the best outcome for all shareholders. The immediate appointment of our Board candidates would avoid the distraction of a public proxy contest and would quickly add highly-qualified individuals with a fresh perspective and focus on unlocking significant value for all shareholders. We do not believe that this request is either contentious or controversial, and are convinced that fellow shareholders would be supportive of a significant shareholder’s efforts to maximize value at Xyratex. Baker Street purchased every share that it owns in the open market and has a tremendous amount of "skin in the game" alongside fellow shareholders, sharing with them both the downside risk and the potential upside of the investment. The owners of Xyratex cannot afford to wait until the next annual general meeting to effect real and much needed change. Shareholders expect and deserve for the Board to immediately implement steps to enhance shareholder value.

Sincerely,

Vadim Perelman
Managing Member
Baker Street Capital Management, LLC

cc: Steve Wolosky, Esq. , Olshan Frome Wolosky LLP