Seagate - Xyratex Deal Shows Seagate Is Serious About SSD

| About: Seagate Technology (STX)
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Seagate Technology (NASDAQ:STX) is making clear that its ambitions in the solid-state drive market might become serious as well following the acquisition of Xyratex (NASDAQ:XRTX).

While the reported deal adds little to revenues and even less to earnings, it is important as a guidance for the future direction of the company.

Just like its main rival Western Digital, shares continue to trade at attractive levels, notably in relation to GAAP earnings. As I am uncertain about future revenue and earnings developments, I remain cautious and stay on the sidelines despite the attractive valuation on GAAP earnings.

The Deal

Seagate announced that it has entered into an agreement under which it will acquire Xyratex. Seagate will pay $13.25 per share, or $374 million for the company. The offer represents a 27% premium compared to Friday's closing levels.

With the deal, Seagate will further boost its HDD ambitions, getting its hands on the capital test equipment business. This deal will further boost the integrated supply and manufacturing chain for disk drives, ensuring uninterrupted access to equipment.

Seagate will furthermore expand into storage solutions as well as high-performance computing, as a consequence of the deal. Note that the actual presence is very limited however.

Dave Mosley who is president of operations and technology at Seagate commented on the rationale for the deal, "This is a strategically important acquisition for Seagate as we continue to focus on delivering best-in-class storage solutions for our customers. As the average capacity per drive increases to multi-terabytes, the time to test these drives increases dramatically. Therefore, access to world-class test equipment becomes an increasingly strategic capability."

Backing out net cash balances of $80 million on Xyratex's balance sheet on August of 2013, the net purchase price comes down to $294 million. The revenue contribution in the fiscal year of 2015 is seen between $500 and $600 million, valuing the operations at effectively 0.5 times annual revenues.

The deal has been approved by the board of directors of Xyratex and is subject to normal closing conditions, including regulatory approval and approval of shareholders of Xyratex. The deal is expected to close in the middle of 2014.


Seagate ended its first quarter of its fiscal 2014 with $2.41 billion in cash, equivalents and short-term investments. Total debt stands at $2.77 billion, resulting in a very modest net debt position. Given the liquidity available, Seagate should be able to easily finance the deal within existing means.

For the fiscal year of 2013, Seagate generated revenues of $14.35 billion, down 3.9% on the year before. Earnings fell by nearly 36% that year to $1.84 billion.

Trading around $56 per share, the market values Seagate at $18.2 billion. This values equity in the firm at 1.3 times annual revenues and 10 times GAAP earnings.

Seagate pays a quarterly dividend of $0.43 per share, for an annual dividend yield of 3.1%.

Some Historical Perspective

Long-term holders in Seagate have seen very strong returns, especially in recent years. Between 2003 and 2012, shares have traded in a $10-$30 trading range. Shares did see a short-term sell-off towards $3 in the middle of the financial crisis.

Since 2012, shares have seen impressive returns, steadily increasing towards highs of $56 at the moment. Between the fiscal year of 2010 and 2013, Seagate increased its annual revenues by a cumulative 25% to $14.4 billion. Earnings rose by 15% in the meantime towards $1.8 billion. Earnings attributable to shareholders did see much more growth, as Seagate retired nearly 30% of its shares outstanding over this time period.

Investment Thesis

Seagate's acquisition of Xyratex is a drop in the bucket, adding roughly 3% in annual revenues. While this looks like big discount compared to Seagate's own valuation, note that the firm is struggling to break-even at the moment, while reporting heavy revenue declines.

Yet it gives the company more access to hard disk drives after rival Western Digital (NYSE:WDC) has been on a buying spree in the area this year. Now it seems both companies aim to boost the presence in the energy efficient solid-state drive market, amidst a declining PC market. In September, Western Digital acquired Virident Systems in a $685 million deal, after buying STEC for $340 million earlier this summer.

These moves are important as Seagate and Western Digital have created an affective duopoly following Western Digital's purchase of Hitachi GST, while Seagate bought Samsungs' HDD business back in 2011. The "temporary" hike in prices following the floods in Thailand, has remained, boosting earnings for the firms despite the PC-worries.

It is these high margins and big exposure to the ailing personal computer market, with lack of exposure to growth markets, which are creating worries among investors. This is despite record high share prices as earnings multiples remain under pressure.

For this reason, shareholders including myself remain in doubt. On the one hand, the valuation accompanied by sizable dividends and repurchases are very attractive. Long-term fundamentals, notably with increasing cloud-adoption can be called "challenging" at best.

Not having great visibility on these outcomes, I remain on the sidelines.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.