QLogic Corp (QLGC)

QLogic (QLGC) manufactures and sells components used in computer data storage networks. The company has 3 primary divisions. Host Products (about 75% of sales) sells host bus adapters, or HBAs, which connect computers to networked storage devices like hard drives or optical media. This division also makes InfiniBand Host Channel Adapters (HCAs), which are used in "supercomputing" applications that require high data bandwidth. The second division is Network Products (~17% of sales), which manufactures Fibre Channel and InfiniBand switches and storage routers. Switches and routers connect different parts of storage networks and route data between them. The final division, Silicon Products, delivers the remaining small portion of sales and is QLogic's legacy business, providing protocol and controller components used in older network architectures.

QLogic has a number of positive factors, one of which is market growth potential. It takes only a rudimentary knowledge of Internet trends to realize the massive amounts of data storage that are required for applications such as social networking, online photo and video sharing, digital distribution of audio and video content, "cloud computing" storage of documents and applications, and so forth. These trends will only intensify going forward, and to efficiently handle storage needs, these storage-area networks (SAN) will become more and more ubiquitous, driving demand for QLogic's products. IDC forecasts a 15% annual market growth for HBAs through 2011, with the overall SAN market growing at an equally impressive 10% annually. SAN vendors are trying to push the technology to medium-size enterprises (it is currently utilized mainly by large firms). Organic revenue growth potential is in QLogic's favor, and the firm has delivered almost 17% annual revenue gains over the past 5 years.

The firm's competitive position in HBAs is strong - they hold nearly 40% market share and form a virtual duopoly with primary competitor Emulex (ELX). It can also be argued convincingly that QLogic is the best run player in the HBA market. They have consistently been taking share from Emulex, who has been embroiled in fighting off a hostile takeover by Broadcom (BRCM). In their newer Fibre Channel businesses (HBAs and switches), QLogic has been grabbing share from competitors such as Brocade (BRCD). In switches, however, QLogic is a newcomer and faces tougher battles. Cisco (CSCO) and Brocade hold dominating market shares here, and are bigger companies with more resources, allowing them to outspend on R&D and marketing, or under-price QLogic if they felt threatened.

The last of the "trinity of investment", financial health, is not an issue here - QLogic is very healthy. The balance sheet shows $340 million in cash and investments, and no debt. Returns on capital are outstanding, averaging 44% on an actual ROIC basis, and 97% on a Magic Formula basis (no goodwill or intangible assets, and using EBIT instead of net income). Free cash flow margin has averaged an astounding 27% over the past 5 years. QLogic has a fortress for a balance sheet and has been a cash cow, just like the best of the tech companies.

So how does QLogic stack up as a potential MagicDiligence Top Buy? Pretty well, and this will be one I keep an eye on as a potential future pick. A few risks concern me. The first is the fast moving nature of technology, particularly evolving tech like SAN equipment. New technologies are forever emerging, both on the high end and low end, creating opportunities for newcomers to get a foot in the door. Also, like most technology, unit average selling prices continue to fall. QLogic has seen its gross margin decline from close to 72% in 2005 to about 67% today, and this deterioration will continue as prices fall faster than input costs. Compounding this problem is QLogic's customer roster, where over 50% of sales are to 3 big customers: IBM (IBM), Sun (JAVA), and Hewlett-Packard (HPQ). If one of these customers decided to drop QLogic, it would be a massive hit to sales. Also, those customers have strong leverage over QLGC to extract price concessions. It's not a desirable situation to be in from a price negotiation standpoint!

Concerns aside, QLogic makes a better than average pick for your MFI portfolio, and could show solid share price gains over the next year as IT spending recovers.

Disclosure: Steve owns CSCO