Emulex Faces Serious Strategic Challenges

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 |  Includes: ELX, MLNX, QLGC
by: The Manual of Ideas

Emulex (NYSE:ELX) has produced strong cash flows due to the duopolistic nature of the fibre channel HBA market, in which it has competed almost exclusively against Qlogic. However, the mid-2007 market entry of fibre channel SAN vendor Brocade may alter the competitive landscape. In addition, fibre channel itself may be under threat from iSCSI (favored by Cisco (NASDAQ:CSCO)) and other technologies. Meanwhile, growth in Emulex’s core HBA segment has ground to a halt due to slow growth in enterprise server shipments. These strategic growth and profitability challenges cause us to stay away.

BUSINESS OVERVIEW

Emulex provides storage networking products, based on proprietary ASICs, in two primary categories:

Host server products [HSPs] include host bus adapters [HBAs] based on fibre channel technology, and converged network adapters [CNAs] based on fibre channel over ethernet [FCoE] technology. HBAs enable servers to efficiently connect to storage area networks [SANs] by offloading data processing tasks from the server. CNAs efficiently move data between ethernet-based local area networks [LANs] and fibre channel-based SANs.

Embedded storage products [ESPs] include storage switches, bridges, routers, and input / output controllers [IOCs] deployed inside arrays, tape libraries, and other storage.

Emulex typically experiences modest seasonality, with lower sequential revenue growth in FQ1 and FQ3.

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INVESTMENT HIGHLIGHTS
  • Number-two provider of fibre channel HBAs, ranking behind Qlogic (NASDAQ:QLGC) in quasi-duopolistic market (Brocade’s mid-2007 market entry may adversely affect competitive dynamics). The market for host server products has grown along with the adoption of storage area networks as a means of accessing enterprise data. HBA market growth is also heavily influenced by server shipments, which have slowed.
  • Strong proprietary technology. Emulex’s fibre channel development efforts began in 1992. The company has 500 engineers and owns significant IP.
  • James McCluney (57) joined Emulex as COO and became CEO in 2006. He was previously CEO of Vixel, which Emulex acquired in 2003. Former Emulex CEO Folino remains executive chairman.
  • Strong balance sheet, with $294 million of cash and short-term investments and no debt.
  • M&A: CEO McCluney wants to “take advantage of our opportunities to grow through diversification.”
  • $140 million repurchase authorized in August.
  • Stock price implies 10% trailing FCF yield and 9x forward P/E (trailing GAAP EPS loss reported).
INVESTMENT RISKS & CONCERNS
  • Guiding for 2Q09 revenue decline of 11-15% and non-GAAP EPS decline of 32-41%, following revenue drop of 5% and EPS drop of 19% in 1Q09.
  • Growing competition, including the mid-2007 HBA market entry by Brocade and the increasing prominence of iSCSI HBA vendors, such as Broadcom (BRCM), Intel (NASDAQ:INTC), and Mellanox (NASDAQ:MLNX). Emulex’s ESPs compete against LSI (NASDAQ:LSI), Maxim (NASDAQ:MXIM), and PMC-Sierra (NASDAQ:PMCS).
  • Large customer concentration, with investors heavily focused on OEM share gains and losses.
  • Marketing head Michael Smith left Emulex in July. He was not immediately replaced.
  • Technology evolution. Storage has evolved, driven by the decline of SCSI technology, the rise of fibre channel, and the market entry of Cisco, which has pushed iSCSI as a fibre channel alternative. Emulex benefited from the decline of SCSI but stands to lose if fibre channel declines. We are reminded of Adaptec, whose HBA fortunes fell along with SCSI.
COMPARABLE PUBLIC COMPANY ANALYSIS (Click to enlarge)
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MAJOR HOLDERS

CEO McCluney 1% │ Other insiders 7% │ Primecap 8% │ Wellington 6% │ Schroder 5% │ Vanguard 3%

RATINGS (Click to enlarge)
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Disclosure: None