|Shares Out. (in M):||99||P/E||0.0x||0.0x|
|Market Cap (in $M):||1,500||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||0||EBIT||0||0|
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I recommend you buy 1 share of QLGC for $15 and hold it for 6.5 years. The upside is enormous if recent history repeats itself (recent history = the last 6.5 years).
You probably know about the old trick of manipulating valuation formulas to tease out the implied growth rate that is baked into the market price of a company… start with the share price and look at what inputs get you that share price - then you know what Mr. Market is thinking. Similarly, if you look at QLGC’s current share price in conjunction with their history of buybacks, and their ongoing cash flow used for buybacks, you would deduce that Mr. Market doesn’t understand basic supply & demand. If the share price doesn’t reach a new supply & demand equilibrium (i.e. go up) then in 6.5 years then the company will have bought back all the shares except yours, and you will own the entire company outright (assuming you don’t sell, and everybody else does).
QLGC has cash on hand to buy back 35% of the company right now, and it produces enough cash from operations to buy about 10 million shares per year. Unlike many companies with strong cash flow, QLGC has steadily removed an average of 12 million shares per year from the market over the previous 6.5 years all the while building the cash balance – thus, QLGC has the willingness and the ability to make our dream happen (dream = CEO of big company in Orange County). So now you’re thinking, “Surf1680 is an idiot. No way Mr. Market is going to let some schmoe like him who paid $15 for a single share of stock own an entire company outright in just 6.5 years!” Maybe not, but this is America and over the last 6.5 years the company did actually remove 65 million shares from circulation and the share price stayed at around $15 the whole time. Why is it so unreasonable to think they can’t take out another 65 million shares over the next 6.5 years at the current share price… leaving just that 1 single share that I own. Call me el jefe.
Ok, now in all seriousness: QLGC is a market leader in interface technology that connects hard drives to servers, and fast computers to other fast computers. You can find numerous industry projections on how this industry will likely grow (search buzzwords: data warehouses, Cloud, Convergence, “Big Data” harvesting, etc.). Humans are creating digital data faster than anything else imaginable and they need a place to store it. QLGC has been successful in this business.
Trying to make a bold prediction about continued usefulness of their technology is beyond the scope of this write up. My thesis is 2 parts: (1) QLGC’s installed market leading technology and substantial R&D budget is good enough to keep it generating cash at existing levels for the next 6.5 years and, (2) management will do the right thing with the cashflow, just as it has in the past.
Investors who currently own QLGC are willing to accept $15/share for it right now because there are uncertainties and fears regarding QLGC. The risks:
(1) Their product lineup could become obsolete and replacement products may not be adopted. Fibre channel could become obsolete to cheaper Ethernet protocols. Ethernet based connectivity has been increasing bandwidth faster than FC based connectivity.
(2) The market is receiving a vague message about QLGC’s new product lineups and ongoing strategy. This is an industry article sums up a lot of the uncertainty regarding QLGC. It attempts to predict where they might be going.
(3) 25% of revenue is from HPQ. HPQ has a shrinking topline and a new CEO. Many aspects of HPQ’s business are likely on the chopping block.
(4) Big % of QLGC cash is stranded overseas. As of April 2011, 67% of cash was held overseas. They will have to pay taxes to bring this back. They don’t intend to repatriate any cash if it means paying taxes.
(5) They have made acquisitions in the past, and they could make a poor one in the future. They have the strongest balance sheet in their industry. I imagine the devils are knocking on the door with acquisition opportunities.
(6) IT spending is cyclical. I don’t know where we are in the cycle but I’m pretty sure we are not at the bottom.
As a general response to all these risks I restate the obvious: They’ve been in business almost 2 decades and they’ve survived numerous technology changes. When they started the internet was a rumor. Now it is core to their business. They’ve survived multiple formats of SCSI, floppy drives, optical drives, and tape drives. They have done so with 67 sequential quarters of profitability. They’ve bought back their entire existing market cap once already (it took them 18 years). Most interestingly, and the core of my thesis, is that in 6.5 years they could potentially buy the entire market cap back again.
Specific points to address above mentioned risks:
For points 1&2: From recent interviews of their Chief Technology Officer.
“In fibre channel it’s not like Ethernet where there are millions of ports and tens of thousands of people who understand it in a lot of detail. In fibre channel, that’s probably thousands of people (who understand it) and the customers are much more demanding.”
“We used to be able to take a fibre channel adapter, back in the days of 2gig, and we would sell that to all the OEMs with hardly any changes. Now as OEMs build vertical product lines, we are spending a lot of effort on differentiation for their specs, customization of our products, different for each OEM”
Paraphrase the CEO from yesterday’s ML/BofA conference “Everyone thought it would die, but more fibre channel ports have been shipping lately than ever,” “If you use QLGC Fibre channel, you’re going to use QLGC FCOE (Ethernet).” QLGC now has the same 55% market share in both interface technologies.
For point 3: HPQ’s biggest segment (personal systems, ~30% of sales, down 15% yoy) has been hurting the most and is rumored to be on the chopping block. Enterprise storage, within which QLGC’s products are sold, is down 10% yoy. The segment is still profitable and HPQ blames recent quarter’s disappointments on supply constraints of hard drives related to flooding in Thailand. Enterprise storage segment is not rumored to be on the chopping block.
For point 4: The CEO said in a recent filing he isn’t going to pay extra taxes to bring the cash back to the U.S. Congress could pass a tax holiday on repatriation taxes, or QLGC could find an acquisition that allows them to use that cash without paying tax (as Merck did with Schering-Plough), otherwise, ~67% of the cash (pre-Intel payment) is offshore. If QLGC pays 35% tax to bring it back, then you may have to wait 8 years instead of 6.5 before you own the entire company outright with your single share. They recently sold part of their business to Intel for $125 mm in cash. All of that cash is in the U.S. and not subject to any repatriation taxes. Based on that, not only is their overall cash on the balance sheet at an all time high but so is their “tax-unaffected” cash balance.
For point 5: QLGC is run by a relatively young (age 43) finance guy – not an entrepreneur or a tech guy. He said yesterday, “No gaps in our product offering, and we see no ripe acquisition opportunities.” He is proud of their long history of buybacks and quarterly profits. There’s a fresh analyst presentation that he gave yesterday at the BofA/ML. He is finding organic growth opportunities. I am impressed by his strategy and market positions: http://www.veracast.com/baml/tech2012/main/player.cfm?eventName=2053_qlogic
For point 6: I can’t pretend to know where we are in the cycle but recent conference calls indicate near term tailwinds and increased market shares. Here is a link to the recent earnings call transcript: http://seekingalpha.com/article/558401-qlogic-s-ceo-discusses-f4q-2012-results-earnings-call-transcript
This business was built on pessimism, quick obsolescence, and shrinking margins. Despite the disclosure, the only thing consistently declining at QLGC is the shares outstanding:
2004 – from 10K: “We expect the pricing of our products to continue to decline…” meanwhile $524 mm sales, 68% gross margin, 192 mm shares outstanding.
2005 – from 10K: “We expect the pricing of our products to continue to decline…” meanwhile $428 mm sales, 71% gross margin, 185 mm shares outstanding.
2006 – from 10K: “We expect the pricing of our products to continue to decline…” meanwhile $494 mm sales, 70% gross margin, 171 mm shares outstanding.
2007 – from 10K: “We expect the pricing of our products to continue to decline…” meanwhile $586 mm sales, 67% gross margin, 159 mm shares outstanding.
2008 – from 10K: “We expect the pricing of our products to continue to decline…” meanwhile $597 mm sales, 65% gross margin, 142 mm shares outstanding.
2009 – from 10K: “We expect the pricing of our products to continue to decline…” meanwhile $633 mm sales, 67% gross margin, 127 mm shares outstanding
2010 – from 10K: “We expect the pricing of our products to continue to decline…” meanwhile $549 mm sales, 64% gross margin, 116 mm shares outstanding
2011 – from 10K: “We expect the pricing of our products to continue to decline…” meanwhile $597 mm sales, 66% gross margin, 107 mm shares outstanding
Despite the drop in shares outstanding, there was no shift in capital structure. They remained debt free and they own most of their fixed assets. They have also been scaling up R&D over the last decade. This company is picking up market share and taking care of shareholders. If you happen to be the last man standing in 6.5 years, at the very least you could end up with a fancy building in Orange County (QLGC headquarters) to call home. Good luck.
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