Why Emulex Shareholders Should Hold Out for More

Includes: AVGO, ELX, QLGC
by: Pierr Johnson

Yes indeed, Emulex (NYSE:ELX) shares were a steal at $6.60/share, however grim its prospects seemed. With $3.45 a share in cash, the stock was trading at well less than its Enterprise Value. Why so glum? A severe retrenchment in Enterprise infrastructure spending has sharply lowered the company’s outlook, prompting a greater-than 50% decline in its stock price. Continued market share erosion against its chief competitor - QLogic (NASDAQ:QLGC) - and an increasingly uncertain outlook for its niche market (Host Bus and Converged Network Adaptors) have further muddied the waters, significantly lowering investor sentiment on the stock and the space.

Broadcom’s (BRCM) now hostile bid for the company is indeed opportunistic. With an abundance of cash and an oversold stock, Emulex was clearly exposed to this. But at $9.25 per share, does it offer fair value for the company and its technology? I think not, for several reasons. First, the offer price is well below the prior year high of ~$15 per share, a level that reflected the more normal economic environment I foresee in a recovery. And for me, valuation should always be forward looking. Even at $9.25 a share, the valuation is just 1.2 times Enterprise Value, which is too cheap for a devices company with a 60% GAAP gross margin and markets that will grow again in an improving economy.

Second, with the emergence of converged network environments, the value of Fiber Channel and hybrid network technologies is, if anything, greater. Simply, the FUD (fear, uncertainty, doubt) was overblown. The design wins the company announced for its new Universal Converged Network Adapter (UNCA) other Fiber Channel over Ethernet (FCoE) products confirm this, as do similar wins announced by its more dominant competitor, QLogic. In short, this duopoly commands critical technologies permitting the inclusion of storage in converging networks.

So I recommend that Emulex shareholders hang tight as the market will eventually confer an appropriate valuation once we are clearly in a recovery. Moreover, though Emulex and QLogic can continue to husband the advancement of these connect technologies on their own, the fact is that multiple Ethernet device companies have the wherewithal to buy, rather than build, this capability. So a competing bid may well arise.

Disclosure: no positions held