“I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities.” (Financial Analyst Journal, 1976)
Security analysis typically evokes a complex and industrious undertaking where, confronted with an overwhelming plethora of facts and opinions, the practitioner settles with the unfortunate necessity to venture his consultation well beyond the point of acceptable uncertainty. When seeking precision in a world that isn’t, guesswork invariably usurps cautious reasoning.
Determined to spare himself both a great deal of drudgery and redundant speculation, the thoughtful analyst therefore focuses his efforts solely on unambiguous and comprehensible situations. In fact, experience has taught him countless times how, in business as in any other endeavour of life, simplicity embodies the ultimate sophistication.
By Thomas Gouttman
Domiciled in Aliso Viejo, California, Q-Logic corporation designs and supplies high performance network infrastructure and connectivity solutions. Organized twenty years ago, the company employs up to a thousand employees today.
The products it sells facilitate the transfer of data and enable the sharing of resources between servers and storage devices. These primarily consist of adapters, switchers, storage routers and integrated circuits.
Sold worldwide, their merchandise is in demand everywhere datacenters, cloud computing, media-rich infrastructure and high-performance networking are administered.
Q-Logic uses outside suppliers and third-party foundries to manufacture its products. As a result, its operational costs are limited and the bulk of its efforts is concentrated toward research, design, development and salesforce expansion.
Its products are incorporated into solutions from a number of original equipment manufacturers. The top ten customers account for 85% of the business; combined together, sales to Hewlett-Packard, IBM and Dell weigh more than half of the net revenue ($559M).
The chief competitors are Mellanox ($300M in sales, and an archetypal Wall Street fad), Emulex ($500M in sales, yet a company that seems unable to remain profitable) and Brocade ($2B in sales, and a name paired with an excellent reputation).
On some segments, Q-Logic also competes with the industry behemoths, expressly Intel or Cisco.
The company is known to exploit the best technology in its particular niche. It is widening its lead in the fibre channel - with a market share above 50% - and keeps actively developing its offer in the 10gig Ethernet category, where it stands as the second most serious contender, trailing Intel.
Q-Logic is unrivaled in its design of ASIC (Application Specific Integrated Circuit) chips, and will soon start shipping its state-of-the-art Mt. Rainier technology, which engenders broad hopes as explosive growth in the SSD (Solid State Drive) market is expected forward.
The traditional fibre channel continues to be solid and stable, and a significant growth opportunity has been identified in the converged networks segment.
The company is ideally positioned to capture those opportunities, as it holds an estimable competitive advantage by means of its strong intellectual property portfolio, along with the distinct incumbency of its offer.
As about the industry, its nature is such as to ease cyclical bumps. Following the latest innovations and releases, spending routinely rises in a hectic fashion. Once equipment gets upgraded, demand returns to average levels.
However, the underlying business trend follows a steady growth, since companies and administrations increasingly invest in the engineering and management of their databases.
There is indeed a significant, secular explosion of computer information. 90% of digital data in the world has been created during the last two years, IBM claims.
If Q-Logic’s enterprise, likewise many of its peers, has lower fixed-cost structures and can generally afford to maintain a lower amount of leverage than companies in other industries, it of course isn’t free of threats.
Besides the significant concentration of customers, their low-switching costs and the difficult protection of patents abroad, the risk of obsolescence, as history tells too well, unceasingly looms the technology companies.
Whether Q-Logic will maintain its edge in the future persists uncertain and purely speculative. The conservative analyst must not venture estimates or projections, but will rather focus his attention on the tangible elements - carried as evidence by the balance sheet - to yield a safer appraisal of the net business’ value.
By doing so, it shall instantaneously appear obvious to him that Q-Logic presently offers a very compelling set of credentials.
Based upon the following records, the company demonstrates an outstanding revenue history, consistent earning power and recurrent double-digit operating margins.
sales op.margin net income
2003: $441 32% $103
2004: $524 38% $134
2005: $572 39% $458
2006: $494 34% $284
2007: $587 23% $105
2008: $598 22% $96
2009: $634 26% $109
2010: $549 18% $55
2011: $597 23% $139
2012: $559 23% $229
The balance sheet carries $858M in assets, $150M in liabilities and $543M in working capital. Completely free of debt, the company sits on a net cash position of $484M, more than half of the current market capitalization. This remarkable feature is, however, partially offset by the fact that a sizeable portion of the balance remains stuck overseas.
Still, given its ample reserve of cash and marketable securities, the business accommodates the financial strength to ride any kind of short-term disturbance. Goodwill accounts for only 13% of assets (Mellanox: 25%; Brocade: 47%), and inventories remain stable.
Over the past ten years, normalized capital expenditures amount for $29M per year, while normalized cash from operations scores $190M per year. The company has admirably managed to maintain its gross margin above 65% of its revenue within the same time frame.
These elements not only illustrate the spectacular profitability of the business and the talent of its managers, they also likely indicate a sizable competitive advantage.
Yet Q-Logic’s pleasant position does not seem irrevocable, as costs of sales, goods and administration (of gross, 2002: 13%; 2012: 20%) and research and development (of gross, 2002: 18%; 2012: 25%) have been perceptibly rising over the past decade.
The part of receivables to gross sales average 12% over the past five years, a low rate which implies that the company is not attempting to gain advantage by offering better credit terms to its clients. Competitors exhibit a similar ratio.
Sifting through the books, the persistent growth of retained earnings - another clear sign suggesting a competitive advantage - is the detail that immediately catches the eye:
(retained earnings, millions)
The returns are gratifying and warrant such apparent prosperity: averaged for the past ten years, the return on equity stands at 19% and the return on assets at 16%. (Mellanox: 17% and 10%; Brocade: 3% and 2%).
However, and to quote the trivial word frequently aired in the street, “one of the earliest lessons learnt in business is that balance sheets and income statements are fiction; only cash flows are reality.”
Fortunately, the Q-Logic’s business does demonstrate a tremendous, consistent and growing cash-generation power:
(FCF per share)
The sum of these features portray Q-logic as a prosperous, efficiently-run, rewarding enterprise.
At the current price of $8.8 a share, the investor of today gets $2 of earnings (EPS) and a healthy return on cash of about 15%.
It is not sufficient for a business to be cheap, it also needs to be safe. On account of its sound financial position, Q-Logic undoubtedly matches the criteria.
But despite its prosperity and bright prospects, the company’s market capitalization had brutally melted by half in less than a semester.
The boisterous panic fit may likely be attributed to (1) the temporary distress surrounding the computer and IT markets, where almost every company up and down the supply chain suffers of negative apprehension, and (2) the stumble of Hewlett-Packard, as Meg Whitman’s firm account for 25% of Q-Logic’s revenue.
Regardless, it shall be reasonably argued that the industry will recover sometime soon; and as about HP, its division selling the equipment Q-Logic supplies actually is the single one that remains profitable.
Consequently, the sudden adversity offers an excellent window of opportunity.
As the icing on the cake, following the inimical release of HP’s trouble with its dramatic write-down, and therefore anticipating further trouble for its suppliers, Goldman Sachs has downgraded the Q-Logic’s stock rating to “sell”.
What better reason to buy?
Just as the American industry appeared to Benjamin Graham during the thirties, the American technology is appearing to the contemporary analyst to be worth more dead than alive.
Based on the current price per share slightly below $9, let us value an investment in Q-Logic’s equity by using three short-term, zero-growth, conservative standards:
(1) Short-term, net asset value + FCF / conservative
(NAV per share) $7 + [(FCF per share) $1.2 x 5 years] = $13
The investor gets a $4 margin of safety when acquiring a share.
(2) Short-term, net current asset value + FCF / very conservative
(NCAV per share) $5 + [(FCF per share) $1.2 x 5 years] = $11
The investor gets a $2 margin of safety when acquiring a share.
(3) Short term, net-net working capital + FCF / extremely conservative
(NNWC per share) $4 + [(FCF per share) $1.2 x 5 years] = $10
The investor gets a $1 margin of safety when acquiring a share.
Net Asset Value (NAV) = total assets - total liabilities.
Net Current Asset Value (NCAV) = total current assets - total liabilities.
Net-Net Working Capital (NNWC) = [100% cash and equivalents + 75% accounts receivable + 50% inventories] - total liabilities.
As stated in the introduction of this article, the conservative analyst must not venture too far in the hypotheses and little-known. Sticking around simple ideas is likely to prevail as a more profitable strategy on the long-run.
One-foot bars to step over, not seven-foot bars to jump over.
Financial literature and academics do typically reward complexity better than simplicity, but a market - it is too often forgotten - is no more than the encountering of supply and demand.
At the speed at which Q-Logic management buys back its own shares - it has been doing so year after year since 2003 - the investor of today may eventually end up being the very last stockholder holding shares among the public, viz. the sole public owner of a company worth a billion dollars!
At that point, the Oracle’s words immediately resonate to the reader’s ears: “When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases.” (Letter to Berkshire Hathaway Shareholders, 1984)
As if selling for less than its intrinsic worth wasn’t enough, the piece of ownership of Q-Logic’s profitable, solid and safe business is running into short supply.
The opportunist investor can hardly miss such a chance to act decisively, notwithstanding the noise and ambient pessimism.
As a matter of fact, he is neither right nor wrong because the crowd disagrees with him. He is right only because his data and reasoning are right.
(1) Business we understand well – CHECK
(2) Demonstrated consistent earning power – CHECK
(3) Tangible and durable competitive advantage – CHECK
(4) Attractive price and compelling margin of safety – CHECK
(5) Able management in place – CHECK
(3) isn’t clear-cut and definite, but is based on the company’s history, know-how and reputation.
BUY [suggested price frame: $6-$10].
The author owns shares of Q-Logic Corporation.
“The worth of a good analyst undoubtedly shows itself decisively over the years in the sum total results of his recommendations.”
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