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On July 22, QLogic (NASDAQ:QLGC) announced results for the first quarter of its fiscal 2011. Driven by cost-cutting, the company posted another quarter of exceptional profitability. However, the good news was offset by the second consecutive quarter of declining revenue for both the company and its core host adapter business. Company revenue of $142.6 million in Q1 represented a quarter-over-quarter decline of 2.13%, with the core host adapter business down 1.16% quarter-over-quarter.

Out With the Old, in With the Old

If you look at a chart of QLogic revenue over the last three years, total revenue of $142.6 million in Q1 of 2011 was nearly the same as Q1 of 2008 when the company posted revenues of $139.8 million. And with host revenue of $102.5 million in Q1 of 2011, the QLogic adapter business has shrunk 1.6% since Q1 of 2008 when the company posted revenues of $104.2 million. Over that 3 year span, investors embraced the lack of revenue growth because the QLogic Fibre Channel HBA cash cow consistently delivered rich profits. Add to that, the company propped up the stock price with $1.5 billion (yes, billion) in stock buybacks.

Fate of the QLogic Cash Cow

Today, over 90% of QLogic revenue is derived from products incorporating Fibre Channel - a networking technology and a market segment destined for change. When the industry accepted the Fibre Channel over Ethernet (FCoE) standard, the fate of Fibre Channel technology was decided -- it would be assimilated into Ethernet technology. The Fibre Channel market was also positioned to become part of a much larger market for Converged Networking. More important, the migration to converged networking has unfolded in unexpected ways which are clearly affecting the Fibre Channel market, the converged networking market, and the QLogic Fibre Channel HBA cash cow.

As the migration to converged networks unfolds, we’re experiencing three unseen trends: IT ambivalence towards convergence, an explosion in demand for 10Gb Ethernet LANs, and critical mass for iSCSI SANs.

Many industry experts expected FCoE and converged networking to be the focal point for customers by 2010. So far, it’s turned out to be true only for OEM customers. Since 2007, server and networking OEMs have been racing to integrate FCoE technology into their latest 10Gb Ethernet products. Surprisingly, the focus of end-user customers is a “network refresh” from 1GbE to faster 10GbE. Few data center managers are aggressively pursuing convergence of their LANs and Fibre Channel SANs with FCoE.

The result is while QLogic reported only $10 million in 10Gb converged product revenue and a decline in overall revenue last quarter, companies with 10GbE LAN/WAN product portfolios such as Cisco (NASDAQ:CSCO), Extreme (NASDAQ:EXTR), and Juniper (NYSE:JNPR) reported healthy quarter-over-quarter revenue growth.

iSCSI SANs Now a Major Factor in the Fibre Channel Growth Equation

The third unexpected trend and a major factor in the Fibre Channel growth equation is the rapid rise of iSCSI SANs. For the last 10 years Fibre Channel has reigned as the exclusive SAN technology for large data centers. When FCoE was developed, many storage industry insiders expected Fibre Channel dominance to continue, and dismissed 1Gb iSCSI SANs as a technology for small businesses. Few thought that iSCSI would be a threat to Fibre Channel today or FCoE tomorrow. Instead, Fibre Channel HBA revenue and port shipments have been stymied because of iSCSI SANs.

Available since 2004, iSCSI SANs have come to dominate medium-sized businesses with 1Gb technology and are now banging on the door of large data centers with powerful new 10Gb arrays. Unlike sales of Fibre Channel storage arrays which slumped in 2009, consumption of iSCSI storage arrays continued to grow and now comprise about a third of new arrays shipped.

IT Brand Pulse estimates that iSCSI array unit shipments - growing at over 20% per year - will reach parity with Fibre Channel array unit shipments in as little as 3 years. As a result, NICs used for connecting servers to iSCSI SANs have eaten about a third of the SAN adapter market. Roughly 3 million Fibre Channel adapter ports will ship in 2010, mostly from QLogic, Emulex (NYSE:ELX), and Brocade (NASDAQ:BRCD). What most people don’t realize is over 1 million iSCSI host ports will ship in 2010, mostly from Broadcom (NASDAQ:BRCM) and Intel (NASDAQ:INTC).

While NICs used for iSCSI have grown to over 1 million ports per year, IT Brand Pulse estimates that industry revenue for Fibre Channel HBAs in the calendar Q1 2010 quarter was $160 million, the lowest revenue level since Q3 2004. IT Brand Pulse also reports that industry port shipments have been stuck between 700,000 and 800,000 ports per quarter since Q1 2007. It's possible that after 2 consecutive quarters of decline in calendar 2010, both industry revenue and port shipments may decline in 2010.

QLogic is performing well in the Fibre SAN market. Unfortunately the market has lost its growth potential because of the transition to FCoE and market share loss to iSCSI SANs. In my opinion, the growth of the QLogic SAN adapter business is now dependent on share gains in the fast growing iSCSI segment.

Positioned for Success in FCoE SAN Segment of Converged Networking

In addition to my cautious view of the Fibre Channel market opportunity, I am concerned about QLogic's position in the converged networking market. I believe QLogic is well postiioned only in the FCoE SAN segment in the overall market for networking converged on Ethernet that includes LAN, FCoE SAN, iSCSI SAN and HPC networking.

LAN — The NIC product line added through the Netxen acquisition has armed the company with a competitive 2G 10Gb NIC. However, OEMs are already shipping 3G Converged NICs, 10Gb NICs that include converged networking features such as iSCSI offload and FCoE offload. I expect next generation converged networking adapters from QLogic to blend proven NIC technology from Netxen with proven Fibre Channel and iSCSI technology from QLogic.

FCoE SAN — In the market for connecting servers to Fibre Channel SANs using Fibre Channel over Ethernet, QLogic is ahead of the pack with a broad suite of chip and adapter products 100% compatible with installed SANs using QLogic adapters.

iSCSI SAN — VMware (NYSE:VMW) just announced support for a feature called 10Gb iSCSI offload because it doubles performance. OEMs know this and QLogic will be at a disadvantage in the 10Gb market until it starts shipping iSCSI offload in future products. And when is the last time you heard QLogic even mention iSCSI adapters or their plans to win market share?

HPC Networking — QLogic has been playing catch-up with Mellanox (NASDAQ:MLNX) in the InfiniBand adapter market since the acquisition of PathScale several years ago. Until the company shows some breakout results, the company will have a small share of the HPC network adapter market.

Bottom Line: Cash Cows Don’t Live Forever

The bottom line is this: QLogic is living off the Fibre Channel HBA cash cow and cash cows don’t live forever. Short-term, iSCSI is cannibalizing Fibre Channel HBA market share. Long term, Fibre Channel technology is being transformed into a protocol running over Ethernet. And to succeed in the new market for converged networking, QLogic must complete a makeover to survive the transition from the relatively low-volume / high-cost Fibre Channel economy, to the high-volume / low-cost Ethernet economy. While making this transition, QLogic also must win a war of attrition against incumbent Ethernet adapter leaders Broadcom and Intel, plus a group of powerful newcomers including Emulex, Brocade and Mellanox.

Disclosure: No positions

Source: QLogic's Q1 Results: Cash Cows Don't Live Forever