Baker Street Delivers Letter To The Board Of Directors Of Xyratex

Mon Jan 14, 2013 6:00am EST

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States That Company is Deeply Undervalued Due to Excessive R&D Spending and
Flawed Strategic Direction
LOS ANGELES,  Jan. 14, 2013  /PRNewswire/ -- Baker Street Capital Management,
LLC (together with its affiliates, "Baker Street"), the largest shareholder of
Xyratex Ltd (NASDAQ: XRTX) ("Xyratex" or the "Company") with ownership of
approximately 23% of the Company's outstanding common shares, today announced
that it delivered a letter to the Board of Directors of the Company (the
"Board").  

In the letter, Baker Street stated its belief that Xyratex' current market price
is dramatically lower than the Company's intrinsic value. Baker Street 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.

The full text of the letter follows:

January 14, 2012

VIA ELECTRONIC DELIVERY  

The Board of Directors
Xyratex Ltd
Langstone Road
Havant, PO9 1SA
United Kingdom

Dear Members of the Board,

Baker Street Capital Management, LLC, together with its affiliates ("Baker
Street"), is the largest shareholder of Xyratex Ltd ("Xyratex" or the
"Company"), owning approximately 23% of the Company's outstanding common shares.
As we outlined in our private letter to the Board of Directors (the "Board") on 
December 21, 2012, we believe that Xyratex is significantly undervalued by the
market and faces serious self-inflicted issues that are depriving shareholders
of the full value of their investment.  

The most important issue facing Xyratex is excessive and unnecessary research
and development ("R&D") spending on speculative non-core initiatives that have
failed to generate positive returns and have severely hurt the Company's
profitability. Xyratex' significant stock price underperformance and extreme
discount to its sum-of-the-parts value indicates that shareholders are
frustrated with deteriorating results and lack confidence in management's
ability to lead the Company to sustained profitability. In this context,  we are
deeply concerned by this Board's lack of urgency in engaging with us in a
meaningful, constructive dialogue to address the issues impacting the value of
the shareholders' investment.

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.

In thelatestearnings conference call, Xyratex management boasted that the
Company's products' "reliability metrics are the envy of the industry." The same
cannot be said for the fate of Xyratex shareholders.The performance of Xyratex
stock has been extremely disappointing over almost any time frame. As shown in
the table below, over the past one-, three-, and five-year periods leading up to
the filing of our 13D, the Company's stock has declined by approximately 36%,
25%, and 50%, respectively, after adjusting for dividends.

                                                                          
                                                                          
                                 Share Price Performance                      
                                                                          
                                 1 Year          3 Year          5 Year   
                                                                          
 Russell 2000                    15.6%           40.4%           6.6%     
 NASDAQ                          14.7%           54.2%           26.0%    
                                                                          
 XRTX                            (35.9%)         (24.7%)         (49.8%)  
                                                                          
 Underperformance vs. Russell    (51.5%)         (65.1%)         (56.4%)  
 Underperformance vs. NASDAQ     (50.6%)         (78.9%)         (75.8%)  
                                                                          


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

Xyratex is  expected to have  $90 million  of net cash at the end of the current
quarter. This implies that at the  January 12, 2013  closing price of  $8.37 
per share, Xyratex iscurrentlytrading at an adjusted enterprise value of only 
$137 million.  As shown in the table below, we believe that this represents 
only 2.2x the EBITDA produced by its market leading core business segments.
Xyratex also trades at discounts to its Tangible Book Value per share of  $10.29
 and even its Net Current Asset Value of  $8.81  per share, a valuation that
implies the Company is worth less as a going concern than its net current
assets, despite the significant value of its businesses and the  $470 million 
spent on R&D in the past five years.

 Market Valuation of Xyratex                                        ($ in millions)  
                                                                                   
 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 Chief
Executive Officer, 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.  

It is abundantly clear that the Board has not held management accountable in the
face of persistent and significant destruction of value. We believe that both
management and the Board clearly understand the reality that, if given the
choice, shareholders would reject this flawed strategy, and would choose the
certainty of significant profit maximization over the current path of perilously
high-risk R&D spending. As a result, the Company is confusing the market and
obfuscating the magnitude of its non-core activities by consolidating its
profitable mature businesses with highly speculative new initiatives.  

The Company's Network Storage Solutions ("NSS") business is the leading original
design manufacturer in the disk storage system industry and its attractive
economics are dramatically misunderstood by the market.  We estimate that the
NSS business today is earning approximately  $52 million  of EBITDA, after
including corporate costs. Based on various valuation metrics for this business,
we believe it is worth between  $210 and $270 million. This range of values is
conservative as it assumes only a small premium to our estimate of the working
capital employed in the segment. Furthermore, this valuation gives no credit to
the Company's patent portfolio and ignores the meaningful optionality of cost
structure rationalization as well as strategic acquisition interest.  

The Company's  Storage Infrastructure ("SI") business is the leading independent
player in the disk drive capital equipment market  with over 50% market share
and an installed base of approximately 3.5 million disk drive test slots. This
business, while cyclical, is attractively positioned in the marketplace with
only one primary competitor and has significant opportunities for operational
improvement. We think it is conservatively worth between  $50 and $70 million.
Based on the competitive dynamics of the disk drive testing equipment market and
the significant strategic advantages of the SI business, we believe that SI
would be valuable to a number of strategic players.  

Based on management guidance, our estimates suggest Xyratex' mature businesses
are highly profitable, with  $62 million  of EBITDA between the NSS and SI
segments, after including corporate costs.

 Illustrative Core Business Economics - 2013E                                           ($ in millions)  
                                                                                                      
 HPC/Cloud Guidance                                                                                    
 Revenue  (1)                                                                        $80              
 Gross Margin                                                                         16               
 OpEx ("Over 30% of OpEx(2)")                                                          (56)             
 Operating Profit of Non-Core                                                          ($40)            
                                                                                                      
 2013E Consolidated EBIT                                                              $1               
                                                                                                      
 Implied EBIT of NSS & SI (Including Corp Costs)                                        $41              
 Depreciation & Amortization                                                           21               
 Implied EBITDA of NSS & 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             
                                                                                                      
 (1) Midpoint of management's $60-100m guidance - Q4 2012 Earnings Call, Jan 10, 2013                      
 (2) Richard Pearce - Q4 2012 Earnings Call, Jan 10, 2013                                                
 (3) Needham & Company 2013 Estimate. In line with management guidance                                    


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 millions)  
                                                                                              
                                                          2005   2013E  (1)  Delta            
 Revenue                                                  $680   $900        $220             
 Gross Profit                                             144    168         24               
                                                                                              
 SG&A                                                     ($39)  ($64)       ($25)            
 R&D                                                      (58)   (103)       (45)             
                                                                                              
 Adjusted Operating Income                                $48    $1          ($47)            
                                                                                              
 (1) Needham & Company 2013 Estimates                                                           


After a thorough analysis of the Company's segments, we believe that  the
current market price ofXyratex 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 millions)  
                                                                               
                                              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.

THE XYRATEX BOARD OWES THE COMPANY'S SHAREHOLDERS A FAIR AND THOROUGH REVIEW OF
THE STRATEGIC ALTERNATIVES AVAILABLE TO THE COMPANY

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.

We believe that a prudent course of action to create certain and significant
value must be weighed against alternatives and would require the Company to
aggressively right-size the business and focus on generating significant amounts
of cash. The resulting profits, coupled with the excess capital on the balance
sheet today, should be returned to shareholders by aggressively repurchasing
Xyratex shares as long as they trade at a discount to intrinsic value. This
return of capital would be accretive, tax-efficient, and would narrow the very
large gap between the current stock price and the Company's significantly higher
fair value. Such actions would also assure shareholders that the Board is
intently focused on intelligently allocating capital and maximizing the
per-share intrinsic value of Xyratex. We vehemently disagree with Mr. Barber's
assertion that the best way to enhance value is to "change market perception by
presenting Xyratex as a growth company" through an increasingly costly pursuit
of non-core R&D projects. To be clear, we reiterate the point that we have made
to the Board privately: we would very strongly oppose any attempt by the Company
to "buy" growth through acquisition or significant capital expenditure.

IMMEDIATE SHAREHOLDER REPRESENTATION IS NEEDED ON THE BOARD TO PROTECT AND
MAXIMIZE VALUE FOR ALL SHAREHOLDERS

Furthermore, as we have steadily examined the Company's recent actions and past
practices, we have grown increasingly disturbed by deficient corporate
governance, which has drained value from shareholders and completely misaligned
Board and shareholder interests.

The nominal equity ownership of independent directors creates a deep
misalignment of interests with shareholders.According to the Company's last
annual report, all independent directors other that the CEO collectively own a
de minimis 70,000 Xyratex shares, or 0.26% of the outstanding shares of the
Company. In fact,members of the Board and  Steve Barber  have been large net
sellers of stock over the past several years.  Having little capital at risk
skews incentives when stewarding the wealth of outside shareholders.
Unsurprisingly, the Board's very low level of stock ownership has led to poor
capital allocation decisions and suboptimal outcomes for shareholders. We were
disappointed that the Board very recently failed to capitalize on a highly
accretive opportunity to repurchase a significant amount of Xyratex stock at a
deep discount to Tangible Book Value, and an even deeper discount to intrinsic
value. A Board member explicitly told us that the Board decided to forgo this
attractive transaction to avoid increasing Baker Street's percentage ownership
in the Company. This decision was made even after we had clearly communicated
our willingness to limit our voting rights if it would allow the Company to
proceed with this value-enhancing transaction. Instead, the Board declared a
special dividend returning only 37% of the current quarter's projected net cash
to keep shareholders at bay and put in place a "poison pill" shareholder rights
plan to entrench itself and buy more time for its flawed R&D strategy.

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.

Xyratex shareholders can no longer afford the status quo.  Without significant
changes at the top, the Company cannot restore the confidence of the capital
markets or address the flawed strategy or profligacy in expenses. This Board's
disregard for its shareholders' concerns leads us to conclude that, as currently
composed, the Board cannot be trusted to conduct an objective analysis or pursue
a sensible strategy that is best for the true owners of Xyratex. It is alarming
that instead of addressing failed strategic initiatives the Board is spending
its energy on fending off fresh, constructive perspectives from its shareholders
and fortifying its positions.  We believe the resistance to new ideas and
thoughtful evaluation of all alternatives stems from a Board that apparently
lacks the proper incentives to act in the best interest of shareholders.  Those
shortcomings render the current Board unable to effectively guide and challenge
management to achieve the best possible outcome for the Company and its
shareholders. Overall, we believe that shareholders have no choice but to
intervene to prevent future destruction of value and ensure their interests are
protected.  

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.

As the largest shareholder of Xyratex, our interests and incentives are directly
aligned with those of all shareholders.  We are deeply cognizant of our right
and responsibility to step in where we feel shareholder value is at risk.
Accordingly, we once again request that the Board immediately appoint our three
highly-qualified candidates who will provide immediate and fresh perspective and
represent the interests of  all  shareholders in the boardroom. Our relentless
focus remains on ensuring that necessary steps are taken to build and maximize
shareholder value. The first and indispensable step is vesting the power to
govern the Company in a Board that has the confidence and support of the true
owners of Xyratex.

Rather than stalling and continuing to make excuses, we urge the Board to
immediately engage with us and look forward to a constructive dialogue to
reconstitute the Board.

Sincerely,

Vadim Perelman
Managing Member
Baker Street Capital Management, LLC

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

About Baker Street Capital Management, LLC
Baker Street Capital Management, LLC is a  Los Angeles-based investment adviser
with a focused approach to fundamental investing in undervalued securities
modeled on the early partnerships managed by  Warren Buffett.

SOURCE  Baker Street Capital Management, LLC


Mark Harnett/Bob Marese of MacKenzie Partners, Inc., +1-212-929-5500, Vadim
Perelman of Baker Street Capital Management, LLC, +1-310-246-0345

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