I like buying companies that don't have any debt because then they don't have to worry about paying it off -- Walter Schloss.
This is one of my favorite quotes by one of my favorite investors. Purchasing companies that don't have any debt can help furnish a much needed margin of safety. However not all debt free companies are created equal - as they could be operating within an industry experiencing secular decline, or could trade at very high multiples relative to their underlying assets. Even though there is potential for attractive debt free businesses to be found in both categories for investment, I believe that buying at a discount to book value can increase the margin of safety for investors.
Qlogic produces hardware for computer networks, data centers and cloud computing. Though QLogic operates in the technology sector - one which is slightly beyond my comfort zone as an investor, it makes tangible products and I believe that there are several factors that make the company an attractive investment going forward. The company has a strong balance sheet, healthy free cash flow, zero debt and a very large cash position. I like companies that have both low to no debt and a very large cash position for several reasons. They can reinvest into growing their business or have the ability to purchase a large amount of shares when the company's share price falls into undervalued territory.
The Numbers on QLogic
Currently priced at $10.06 per share, QLogic has $5.12 of cash per share and zero debt with a P/E ratio of 12.9. Subtracting the cash from the price of the company and investors are left paying $4.94 for $8.16 of book value. Factoring out the company's large cash position, the P/E ratio of the company is closer to 6.3. The company also trades at approximately 6.2x Free Cash Flow - indicating strong earnings power of the underlying assets.
Though the company has a large cash position currently, it is important to note the cyclical nature of computing hardware and the potential for significant capital expenditures over a long term period as technology advances. Despite this fact, the company currently appears to be a lean enterprise and is poised to benefit from the continued growth of cloud computing and increasing demands for data transfer.
The company has also recently engaged in corporate restructuring, reshuffling management, cutting jobs and saving an estimated $20 million annually going forward after incurring a single charge of $23 million.
As it stands now, the company is priced approximately 30% under book value plus cash per share. In another article, a fellow contributor with three decades of experience in the IT field discusses the development of the company's new technology and products in an extremely cogent fashion. The contributor makes a very persuasive argument about the potential for an acquisition by a larger company due to the valuable nature of the intellectual property held by QLogic.
I believe that the potential for an acquisition increases measurably when the company's assets are offered at such a large discount relative to the price of the stock currently. Though I believe that QLogic represents a safe investment on its own, having the potential of a large one-time gain through an acquisition is attractive.
As with much technology, the risk of products becoming irrelevant due to disruptive innovations is very high. In addition, the generational nature of much of QLGC's business means that the company must constantly innovate and expend capital for research and development or risk erosion of earnings power. Another risk is that since QLGC supplies its hardware to OEM's, its earnings could suffer if a large customer such as Dell (NASDAQ:DELL) or HP (NYSE:HPQ) encounters further deteriorating conditions.
Despite the highly competitive sector in which QLGC operates, I believe that there are compelling reasons to justify the purchase of QLGC shares at these levels, particularly if the price declines another 10% or so, widening the discount to book value at which the company's assets are offered. Though there is a potential for an acquisition providing a catalyst for revaluing the company's shares, I believe that the company also has a promising future as an independent entity due to its strong balance sheet and presence in a growing industry.
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.