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The Case for Xyratex (XRTX)

|Includes:Xyratex Ltd. (XRTX)
I know I have been touting XRTX, but that is because of the unbelievable value that it offers to investors!  Xyratex suffers from a lumpy business model and limited analyst coverage.  However, there are a series of strong secular trends in the enterprise storage space that Xyratex will benefit strongly from.  It is trading at about 6x earnings when adjusted for a higher tax-rate as the company benefits strongly from the tax shelter associated with being incorporated in Bermuda.  There is money to be made in Xyratex as Q3 is out of the way and a new bar is set for Q4.  The fifteen percent sell-off in the stock after it reported Q3 earnings that beat expectations by 20% cleaned the slate for new investors to come in and make some money.  After all, there is something to be said when a stock is up 5% on heavy volume on a day when markets are down 1-2% as was the case yesterday 10/4.  In attempt to get the word out, below are a series of drivers for this stock.  

Growth in Data Generation and Storage. 
IDC research estimates the pace of data generation to grow at a CAGR of 50% over the next four years.  This growth is driven by digital archiving, regulatory demands, business continuity and US stimulus actions including the rollout of electronic health records for all Americans by 2014.  As of 2Q10, Xyratex is shipping storage capacity of 3,397 petabytes (NYSE:PB) representing growth of 59% y/y and 15.2% of worldwide external storage.  Digital content demand and storage systems capacity is expected to increase to 907,000 PB and 54,480, respectively by 2013, up from 196,00 PB and 11,491 PB, respectively in 4Q09.  XRTXs customers continue to install incremental production capacity to match end user demand and late substrate supply, strongly benefiting the SI channel which is on pace to grow 121% y/y.

Hard Disk Drive (HDD) Market Growth and Increased CapEx.
According to TrendFocus, digital content and HDD demand is expected to growth at a CAGR of 54% and 12%, respectively through 2014.  The steady demand for hard drives is fueled by the high growth of digital content and enabled by continual technological improvements in areal density.  2Q10 marked a 97.8% sequential increase in capital spending across Xyratex’s customer base with the company capturing approximately $58 to $70 million of capex spending by Seagate and Western Digital so far this year.  Substantial capital spending is expected to continue through the 2H11.

Hitachi Contract Win. 
During 2Q10 Xyratex completed a competitive technical benchmark by Hitachi Global Storage Technology (HGST), in which XRTX was awarded HGST’s back-end test business.  Xyratex expects approximately $10M of revenue from HGST in the 2H10; however management believes that “over time the relationship can grow to be quite meaningful”.  Over the next three years, it is expected that this relationship can grow to 50% of each Seagate and Western Digital, adding 5-10% to overall SI revenue growth.  This new business is characterized by 30% Gross Margins which is twice that of current margin levels.

Disclosure: No Position
Stocks: XRTX