QLogic: Capital Allocation Is On Your Side

by hihih222

I’m finally going to get to a point where I have the time to do what I consider ‘adequate’ stock research starting January! That means this blog will finally have some real value for readers. More importantly, as this blog serves as my personal investment record, I will finally have time to get in the investment research groove and perhaps learn a bit as I go.

QLOGIC

I was really interested in QLogic a little while back. At prices under $9, it appeared on its face to be selling for less than 4x FCF(ex-net cash). A deeper look showed it isn’t the value it appeared to be. Most of the cash is held internationally, so to be value conservative you have to account for repatriation taxes. Also, I’m not accounting expert(yet) but it seems that FCF is overstated because it’s adding back option expenses that need to be accounted for when looking at the real business’ earnings power. The company has been profiled a few places now. ValueInvestorsClub has a writeup, Barel Karsan has a writeup, and here’s Graham Disciple’s Writeup.

QLGC gets a bad rap and it’s partly their fault. Management keeps warning investors of their high customer concentration and the pressure on their gross margins, as good management should, but they conveniently forget to explain why this doesn’t seem to be an issue for the company. As the ValueInvestorsClub article shows, they’ve warned about expecting major gross margin declines in their 10-K for the last 8 years, and over that time we’ve seen almost no real gross margin declines. QLogic has higher gross margins than competitors(~5% higher than Brocade and ~8% higher than Emulex) and has large and growing Fibrechannel Market share(55%). Why is this? I won’t claim to completely understand the industry, but it seems to be the same reason that their customer concentration “risk” isn’t so risky. Customers in this business are sticky. QLogic collaborates with their customers very early in the design process, so while customers could switch suppliers, it’s very inconvenient. First of all, product design cycles are long, so a customer would have to get the timing right if they wanted to leave QLogic, else they’d miss a potential product update and fall behind competition. Second, the relationship between QLogic and its customers has grown in value over time, and I assume that customer isn’t eager to have to rebuilt that kind of rapport with another supplier.

So QLogic’s customers are sticky, and QLogic has high and growing market share and top of the industry gross margins(if not by much). Competitive Advantage? Possibly. QLogic might have an advantage in switching costs and maybe brand? I’ve heard that both QLogic and Brocade have much better brands than Emulex, but I’d need to look into that further.

Temporary Problems

Right now, the business is undergoing temporary problems. Their bottomline customers are facing cyclical pressure(so their business is also facing the same pressure as a result). Also, with HP’s recent problems, there is a worry in the market that HP’s business might be at risk.  I don’t think there’s a risk here and neither does Graham Disciple as he says, “about HP, its division selling the equipment Q-Logic supplies actually is the single one that remains profitable.”

Valuation

Looking at average revenue and margins and adjusting for one-time expenses, I get normalized sustainable earnings at 80M to 100M. Depreciation seems to overstate capital expenditures by about 10M although I’m not sure why. As interest rates are so low and the business has such high market share, I think the cost of equity(there is no debt) is fairly low. I peg it at around 8%. That means I have 1B to 1.25B as the value of earnings power w/o cash, and with cash I’d probably peg intrinsic value at about 1.25 to 1.5B($13.5 to $16.5).

Capital Allocation and Intrinsic Value Growth—Potentially Great?

With so much trapped up cash on the balance sheet, at first I thought this was a classic bad business with too much cash it doesn’t know how to invest. However, when you actually look closely at QLogic, you realize that while there isn’t much room for investment in growth in QLogic(they do have some innovation in R&D expenses with their Mt. Rainier technology, but I’m not believing the growth till I see it), management is allocating capital very well at the moment. Every year, management spends substantially all of the company’s free cash flow on share repurchases. While this may or may not have created value in the past, for a potential investor in QLGC at $10 or below, this is fantastic news. Essentially, unless you earn 30% on your investment and share repurchases occur at $13, the company is likely going to have returns at or above the cost of capital on its share repurchases, assuming my intrinsic value calculation is correct(increasing intrinsic value if the price doesn’t go up…a win-win situation). If you actually look closely, the company has had 350M in cash on their books for a long time(the sudden jump this year was due to a sale of a division). It appears that management decided at 350M their balance sheet was strong enough to survive any cyclical downturn and maintain market leadership, so they’re putting all incremental cash flows into share repurchases. So clearly, if you buy QLogic now, you’re going to get high returns on incremental capital if management continues its buyback strategy(highly likely). If management continues to buyback shares at this rate, they’ll have bought the entire market cap within 7 years, so consider the buybacks a very nice catalyst.

You’re not just getting high incremental returns though. The business is a cash machine. Assuming they only need 2% of cash on hand at all times as working capital, QLogic has 306M in invested capital. If normalized earnings are 90M, QLogic is consistently earning 30% returns on capital. If you buy now, you get 30% returns on capital and incremental returns on capital above the cost of capital until the share price gets to $13-$16(my rough estimate of intrinsic value).

So oddly enough, if you’re a QLogic shareholder right now, you should be hoping and praying that QLogic shares stay depressed for as long as possible because while you have a quick 30% upside now, intrinsic value grows at a very high rate of return if shares can be repurchased at these low prices for a long time.

If Intrinsic Value grows while prices are below $13 and when prices are above $13 you can cash out at a 30% return, it would seem to be a win-win situation. I’d still be cautious before investing in QLogic. I’m outside of my circle of competence with this stock’s product, and before I’d ever invest in the company, I’d have to do in depth research on QLogic’s technology to better understand product economics and competition dynamics in this industry. What makes QLogic better or worse than Brocade, a company 2.5x the size of QLogic? I don’t know, and I’m not going to invest yet because I don’t think a 30% margin of safety is enough to make up for an investment outside of my circle of competence.

Disclosure: I own no positions in any companies mentioned.

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