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Two weeks ago, I announced my intention to create a portfolio composed of 10 companies that investors have unjustly cast aside. My goal in creating the One Person's Trash Is Another Person's Treasure portfolio is to highlight just how successful value investing and contrarian viewpoints can be, as well as uncover some great companies that have a good chance of turning their fortunes around. For a more thorough explanation of what I hope to accomplish and how I'll measure my success, I encourage you to visit my portfolio mission statement.
For reference, here is my inaugural selection:
For my second selection, I've chosen integrated circuitry provider QLogic (Nasdaq: QLGC ) , a company I do own in my personal portfolio.
Why traders have given up on QLogic
Simply put, traders tend to give up on QLogic about once every three years, since it's a highly cyclical tech stock. QLogic is an integrated circuitry manufacturer, making specific adapters and switches to enhance and manage computer data communication. As you might expect, as technologies change and newer models replace older models, and as economic growth fluctuations, QLogic's business is bound to suffer from supply and pricing issues, as well as cycles of increased and decreased research and development costs.
In QLogic's latest quarter, we received evidence that we're smack-dab in the middle of another cyclical downturn. Operating profits declined 57% while operating margin dropped a woeful 22.6% as expenses ticked 5.6% higher. Revenue fell across all three of its segments, host, network, and silicon products, with its most-important host products segment seeing sales decline by 13.4%.
However, QLogic isn't the only company taking it on the chin. Cisco Systems (Nasdaq: CSCO ) , while upbeat in its latest report, has been stymied by European growth woes for multiple quarters and has resorted to layoffs to help keep expenses under control. High-flier Mellanox Technologies (Nasdaq: MLNX ) was grounded after its fourth-quarter revenue forecast came in $10 million lighter than Wall Street had anticipated. Even small players like Emulex (NYSE: ELX ) are struggling. The networking and storage products provider noted a 43% drop off in storage connectivity products in its latest quarter.
In short, we know there's an industrywide downturn, we know businesses are tightening their spending, and when in doubt, dogpile onto these companies.
Why investors should trust QLogic
Perhaps I should rephrase this section to "Why I bought QLogic in the first place."
The first factor that comes into mind when I think of QLogic is that network service providers and enterprise providers are constantly needing to upgrade their infrastructure, be it through back-office cloud-computing, or standard infrastructure, in order to keep up with an extremely digitized world. Earlier this month, AT&T (NYSE: T ) announced a plan to spend $14 billion on wired and wireless upgrades over the next three years. Intel (Nasdaq: INTC ) is spending a pretty penny on upgrading its hardware line to take advantage of the cloud-computing revolution. To put it mildly, the spending will be coming QLogic's way eventually -- the timing itself as to when that happens isn't nearly as important.
Another important point about QLogic is its original equipment manufacturer, or OEM, partnerships with some of the biggest networking and cloud players in the industry, including EMC, Cisco Systems, Hewlett-Packard, and Oracle. With all four of these companies suffering from weaker-than-expected growth recently, you might be wondering "OK hot shot, how is this a positive?" The reason these OEM contracts, and the addition of new contracts, are positives is they provide QLogic with relatively steady recurring revenue which is the key to its profitability and predictable cash flow.
What you'd get here
The third very important reason I took a position in QLogic was its incredible valuation and history of top-notch performance.
You're probably very well aware that we've had two recessions over the past decade. What you may not be aware of is that QLogic was profitable in each of the past 10 years -- and not just marginally profitable; we're talking very profitable! Full-year EPS has ranged from a low of $0.47 in 2010 to as high as $2.23 in fiscal 2012 over the past decade. Even with predictable spending on R&D, QLogic has in excess of $133 million in free cash flow in all but one year over the past decade.
What this has translated to is a company that's very rich in cash and able to use that cash to fund R&D, pursue acquisitions as it sees fit, and perhaps return money to shareholders in the form of a dividend or share buybacks as it sees fit in the future. (Hey, a current shareholder can aspire right?)
QLogic ended its most recent quarter with $484.4 million in cash with no debt. Running the math, that works out to $5.22 per share, yet it closed yesterday at just $8.97. Using more of that hocus-pocus math stuff, you'll see that for just $3.75 (excluding cash) you're getting a business that's expected to produce $0.77 in EPS this year and $0.85 next year. I'm honestly wondering just how inexpensive investors are going to let this get before the light bulb goes off in their heads that says, "Hey, QLogic is profitable and its products are going to be a hot commodity on the next upswing in the networking sector!" At 10 times forward earnings and with a boatload of cash, I made the decision to add QLogic to my personal portfolio, and that's why it's being added to the One Man's Trash Is Another Person's Treasure portfolio.
Check back next week, when I unveil the third selection to this portfolio.
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