Xyratex is a market leading provider of modular enterprise-class data storage subsystems and hard disk drive capital equipment. The company operates in two primary segments: Networked Storage Solutions (NSS) and Storage Infrastructure (SI).
As depicted below, it's evident that each product line enters the value chain at different points. Where the Networked Storage Solutions (NSS) is in the latter stage of the process, primarily serving the needs of Original Equipment Manufacturers (OEM's) and the Storage Infrastructure products are earlier in the process to directly service the hard disk drive producers.
NSS products provide modular, highly scalable, high-speed, high-density, high-availability,reliable, and flexible data storage. The hard disk drive (HDD) based storage subsystems support a range of high-speed communication technologies to meet demanding cost and performance specifications. Modular subsystem architecture facilitates support for segments within the networked storage market by enabling different specifications of storage subsystem designs, including Solid State Drives (SSDs), to be created from a standard set of interlocking technology modules. Xyratex is the largest OEM disk storage system provider.
The SI product portfolio includes process, inspection and test equipment utilized in Disk Drive Assembly and Integration, Disk Drive Substrate and Media Manufacturing, and Disk Drive Head Fabrication. Xyratex estimates that around 50% of the industry’s hard drives are processed on Xyratex equipment. Based on the June 2010 bi-annual HDD capital equipment report from the independent market research firm Coughlin Associates, overall SI revenue represents approximately 11% of the HDD industry’s capital equipment spending. 
|LSI Corporation||LSI||3.99 Billion|
|EMC Corporation||EMC||55.15 Billion|
|Dot Hill Systems||HILL||163.36 Million|
R&D is essential in the development of a technology company in that without innovation, the company would have no future growth prospects as obsolescence is very prevalent within the technology space. To combat this Xyratex maintains 25% of its employees in its Research and Development practice; employees have an average of over 10 years of experience in product research and development.
Xyratex typically undertakes between 8 to 10 significant development endeavors annually. Projects are evaluated semi-annually to adjust investment capital as needed. Over the past three fiscal years they've invested $250 million in R&D. A substantial portion of projected revenues in FY2011 are dependent on development programs undertaken in 2009 and 2010. 
The United States Environmental Protection Agency (EPA) is expected to release regulation specifying power supply efficiency. In lieu of anticipated regulation, Xyratex has ongoing research and development focused on power supply efficiency in their Energy Star storage systems. Combined with the already innovative power management architecture, assuming regulation is passed, this will be a key advantage for OEM customers.
A broad patent portfolio is indicative of innovation, currently Xyratex maintains 421 patent filings worldwide. Xyratex's broad footprint with development activities located in India, Ukraine and Malaysia incorporates a global perspective of innovation.
Referenced in Figure 1.2 are R&D expenditures across Xyratex's primary competitors in the Data Storage space. The most notable observations are premised as a function of scale, where in general EMC, with a capitalization of $55 billion is able to leverage the advantages of its large scale. Although, the more pure-play data storage company, LSI, is able to leverage its capitalization of $3 billion to allocate nearly 25% of its revenues to R&D - one of biggest expenditures in the data storage space. Given that Xyratex only allocates a mere 8% of Revenues to R&D, it could pose a threat to future growth if they fail to deliver innovative products in a rapidly changing segment of technology with short life cycles. 
Xyratex's operational strategy is to provide production facilities in close proximity to their customer base. As such, production facilities are based in California, United States, Malaysia, and the United Kingdom. These facilities share a common SAP based ERP system facilitating integrated processes which are accessible from any location. This provides the flexibility to move manufacturing operations from one region to another in order to meet the logistics requirements of customers.
Xyratex established strategic relationships with key suppliers for the supply of core components and subassemblies, including printed circuit board assemblies, HDDs, plastic moldings, power supplies and sheet-metal fabrication. Thus enabling production facilities to focus on material planning; high-level assembly operations; system configuration and testing and customer fulfillment activities.
Xyratex sells and markets its products primarily to leading OEM's and disk drive manufacturers, typically U.S. companies with global operations. Sales and marketing operations are primarily reliant on developing strategic relationships based on technical expertise. New business development is typically through industry associations and customer-sponsored events. The sales team is comprised of 270 employees. 
As depicted in Figure 1.3, Xyratex has a global footprint with sales coming from three main sources; North America, Europe and Asia. As you can see, there has been a shift towards convergence where the European and Asian sales have grown, while the North American sales began to atrophy. Xyratex continuously looks for efficiencies and improvements in supply lines that can benefit customers. As such, Xyratex is well positioned for global growth - this is attributable to key management experience in operating international businesses. For example, in 2007 they established NSS product manufacturing in Malaysia as customers’ demand in the Asia region increased.
At first glance it seems as if the key executives are lacking Ivy League degree's and the credentials of a more decorated management team. However both the CEO and CFO were a part of the company prior to its management buyout from IBM. That experience afforded them the opportunity to observe the company's operations as part of a cog in a big corporation and conversely as a standalone unit. The ability to oversee the company throughout the entire process forced management to have a deep fundamental understanding of the operations and structure of the business. As such, they've replaced decorated education with much more valuable tangible operating experience within the firm. Ultimately, the fact that management has skin in the game as part of the buyout makes this management team much more valuable than prestigious education. 
Medium - Rivalry exists in a few different forms for Xyratex. The first being companies providing storage subsystems and components to OEM's that primarily compete with the NSS unit. These include Dot Hill Systems Corp, LSI Corp, MiTac International Corp, and Sanmina-SCI Corp, along with suppliers like EMC and Hitachi. Additionally there are competitors that acquire companies with intellectual property competing in the space; which typically compete with the SI unit. Furthermore, there are in-house development efforts by existing customers that could potentially eliminate the use for Xyratex products. 
Medium - Barriers to Entry are primarily guarded by intellectual property protection. With 126 patents granted and 169 patents pending, Xyratex has done a sound job in developing innovative products and safeguarding them with patent protection. On the flip side, the patent-life is limited and once expired can open the doors to competitors; but as a corollary, since the technology life cycle is continuously evolving, obsolescence is rampant and thus replication isn't as prevalent of an issue as it is in other industries.
Low - The only viable substitute to HDD storage is Solid State Drive (SSD) storage. In contrast to the HDD's, the SSD's use microchips to store data in non-volatile memory chips that contain no moving components. Thus, SSD's are less susceptible to physical shock and don't make noise. However, the SSD's have a limited number of writes in a lifetime, and cannot be overwritten. Moreover, the cost of an SSD drive per GB is $1.20-2.00, where an HDD is roughly $0.05-0.10 per GB. As noted by Gartner, a technology analytics firm: given SSD's significant cost, they are not a significant short-term threat, but are poised for growth in the next few years, primarily driven by mobile devices. Currently SSD's make up 1% of the total storage market and as depicted below are expected to reach 8% in 2014. However, HDD's still continue to dominate the market throughout that time as depicted in Figure 1.5 using forecast data from Gartner. 
High - While Xyratex has a small customer base, it should be noted that the industry itself has consolidated over the past decade and is rather concentrated as a whole. That being said, Xyratex has a relatively small customer base, in which leads to an increased power to the purchasers of their products. Overall, Xyratex has approximately 100 customers of which the top six compose 91% of revenues (Figure 1.6). As a corollary, three of Xyratex's customers in the HDD space comprise 80% of the total HDD market. In 2010 HDD sales, Hitachi, Seagate and Western Digital had a market share of 18%, 30% and 31% respectively. Given the fact that the HDD downstream space is dominated by only 3 firms, this weakens the bargaining power of upstream suppliers such as Xyratex. 
High - Given the nature of enterprise data storage subsystems, the input components are highly specialized. As such, the supplier power remains very high because there are few suppliers of these specialized products. For instance, one of Xyratex's primary components, Electronic Printed Circuit Boards, are bought from one supplier, Flextronics International. The reliance on a sole supplier results in reduced quality assurance, increased production costs, and a reduced product supply. However, Xyratex has attempted to mitigate this risk by avoiding the use of long term contracts and elected to utilize purchase order agreements instead.
In 2010, Xyratex acquired the cloud computing firm ClusterStor and its Lustre development team. Lustre is the leading high performance clustered file system in high performance computing, and experiences a 60% market share in the supercomputing space. Going forward, Xyratex can leverage the Lustre platform to deliver next generation high performance computing solutions to its OEM clients. 
Strong Forecasted Demand
As evidenced in Figure 1.8, while there's projected atrophy in the Desktop Computing segment, there is strong projected growth in the HDD space, primarily driven by personal storage. As we see an immense increase in both data usage and size, there is a strong demand for personal storage. This has been driven by recent innovations in the technology space:
However, as Xyratex has been focusing on the enterprise-class market so far, it remains to be seen whether it can exploit opportunities in the personal storage segment of the HDD market.
Market Leadership in Growing Cloud Market The creation and distribution of entertainment content is the largest driver in the growth of digital storage. Acquiring, editing, archiving and distributing digital content together with increasing distribution over the internet and digital cinema technology deployment all require large amounts of storage. 3D technology requires even greater data storage performance and capacity in the post production process. High Definition digital camera technology continues to replace film in movie production and high definition television channels increase both the performance and capacity demanded of data storage systems. The high performance computing market consists of large research organizations, educational institutions and commercial research applications. This growth plays right into the hands of Xyratex, who acquired ClusterStor in 2010. Having retained the Lustre focused management team, the firm is well positioned to take advantage of surging growth in the high performance computing space. Integrating the new firm into current operations will be essential to leverage Lustre's 60% market share of supercomputing site storage.
Xyratex maintains roughly 100 customers, of which the top six (NetApp, Dell, IBM, Seagate, Western Digital, and EMC) comprised 91% and 87% of revenues in 2010 and 2009, respectively.
Since Xyratex continues to deliver customized solutions, it results in a lengthy sales cycle that could take up to 18 months to complete. When it takes 18 months for a customer to evaluate the technology, and the product has a relatively short life cycle - this poses a problem with obsolescence of products. However, this is often negated because the product is customized directly for each clients specific needs, where obsolescence is less prevalent.
Xyratex has proven time and again its ability to innovate and protect its products with its 421 patents. However, since these protection measures have limited lives, they present the opportunity for another firm to replicate Xyratex's innovative products. Since this is the primary barrier to entry, competing firms pose the threat of Intellectual Property theft or replication.
Given Xyratex's highly concentrated customer base, the loss of one of the aforementioned clients would entail a material loss to the business. However, since Xyratex partners with suppliers and manufacturers to develop customized solutions, they are able to leverage specific client needs to maintain these relationships.
Technology in general has a very short life cycle and is constantly threatened by new technologies, new products, new standards and ultimately obsolescence. Thus, it becomes imperative for Xyratex to continue to deliver innovative products by investing in Research and Development. Going forward, continuing its technology leadership and delivering customized solutions to customers are important in mitigating the risks of a lengthy sales cycle paired with a products with a short life cycle.
Since Xyratex's innovative products are protected solely by trade secrets, patents and copyrights, replication is rampant. Thus, to continue to be a market leader, it is imperative Xyratex continues to innovate and protect its development endeavors through patent protection.
Calendar year 2010 experienced a wave of consolidation in the data storage space. Primarily driven by strong forecast growth, optimism in the industry led to robust valuations seen in huge premiums paid in acquisitions - led by the HP acquisition of 3-Par with an 82% premium over pre-bid share prices.
Shortly after issuing a dividend in January 2011, the stock was further beaten down by lower earning guidance in April. Which has led to a valuation of 0.13x EV/Sales and 1.71x EV/EBITDA within the early stages of 2011. While trading well below its 200-Day Moving average of $13.98, it's share price has met resistance at the $10 level. With a tangible book value of $12.18 and a current share price around $10, Xyratex is seemingly undervalued. Given Xyratex's strong market position in a rapidly growing space, with no debt, Xyratex makes for a prominent takeover target during a time where purchase price premiums are frothy.
The figures below are represent comparable values amongst 15 (all-cap) Data Storage Comparable Companies.