QLogic Corporation: A Qualified Value Opportunity?

| About: QLogic Corporation (QLGC)

QLogic Corporation (NASDAQ: QLGC) designs and supplies enterprise network infrastructure products. As of the time of writing (8/2), the company is hovering around 52 week lows as a result of a sharp sell off following the company’s fiscal Q1 earnings release. The company beat consensus EPS by $0.04 and revenue by $1 MM, but issued underwhelming guidance.

I am wary of large price declines resulting from guidance alone, so when I see this happen I tend to take a closer look to see if there is a value opportunity.

The company trades (as of 8/2) at a P/E of 11.16x, but has approximately $400 million in cash and securities on hand and no debt, so its P/E ex-cash is just 8.35x. There are many things to like about these facts, but the focus should be directed to the massive cash balance (~25% of its market cap!) and complete lack of debt, which translates to greater financial flexibility and reduced risk, all else being equal.

Before I get emails about the folly of mentioning P/E, let me say this: I use reported P/E here for illustrative purposes only and I almost always ignore this metric. I recognize that earnings are often quite volatile (despite the best efforts of management to smooth earnings), which severely limits the use of the P/E multiple. A superior metric is the PE10, which uses the average net profit margin over the last ten years and the current revenue to calculate a more stable metric of the company’s current price to earnings power. The one drawback of this method is that companies in decline will benefit from historically superior profit margins. This does not appear to be the case for QLGC, so I calculated its PE10. Guess what? Its PE10 is 11.13x, or essentially the same as its current P/E, so the earlier mention of its P/E ex-cash pretty accurate relative to its long-term earnings power. This translates to an ex-cash earnings yield of 12%. Not too shabby.

Earnings are great, but free cash flow is what drives stock returns, so let’s take a quick look at FCFFs.

QLogic Corporation - Operating Metrics, 2002 - 2011

QLogic Corporation - Operating Metrics, 2002 - 2011

As this chart indicates, the company’s free cash flows have tended to be above reported earnings and track quite closely with cash flows from operations. From this, we can infer that the company has relatively low and stable capital demands, and the company’s reported depreciation tends to exceed annual capital expenditures. Both are good things. Over the last decade, the company has generated $1.39 billion in cumulative free cash flow, which is more than its current market cap less cash on hand.

So what is the company doing with its free cash flow? Returning it to shareholders. Let’s look at the company’s share count:

QLogic Corporation - Shares Outstanding, 2002 - 2011

QLogic Corporation - Shares Outstanding, 2002 - 2011

The company has repurchased 45% of its shares outstanding since its peak in 2004, representing the return of $1.42 billion of cash to shareholders. Spectacular!

Let’s take a quick look to see whether the company is growing revenues and whether margins are eroding.

QLogic Corporation - Margins, 2002 - 2011

QLogic Corporation - Margins, 2002 - 2011

From this, it appears that the company has experienced only moderate growth since 2005. It appears that this might be the result of the company’s reliance on Fiber Channel products. QLGC dominates this market, which comprises the vast bulk of its revenue. Unfortunately, this market seems to be stagnant, as the emergence of FCoE has led to greater emphasis on Ethernet technology. I am far from an expert here, so if I am incorrect, please let me know in the comments below. In the Ethernet industry, the company faces competition from better capitalized and well entrenched players, such as Cisco (NASDAQ: CSCO)

In valuing QLGC, I used long-term margins and current revenues, but incorporated a negative growth factor of varying degrees (depending on the scenario). I found QLGC to be undervalued by a sizable amount, but I have neglected to purchase for a few reasons, the primary of which is that the company’s revenues are highly concentrated. Hewlett-Packard (NYSE: HPQ) accounts for approximately 1/4 of revenues, IBM (NYSE: IBM) around 20% and Dell (NASDAQ: DELL) at 11%. The loss of any of these customers would have a major effect on the company’s operations, and this is a risk I am not willing to take.

One other thing that I like about the company: On February 10, 2011, the company announced that it had entered into “Change in Control Severance Agreements” with two executives, ensuring these executives would receive payouts if the company were acquired. In October, the company made similar assurances to its new CEO and Executive Chairman. These agreements sometimes signal behind-the-scenes acquisition discussions. Given the time that has elapsed now, this is probably idle speculation but given the company’s free cash flows and lack of debt, I can think of worse acquisition targets.

What do you think of QLogic?

Disclosure: No position