QLogic Shares Rest Easy

Updated from 1:15 p.m. EST

After a 2-for-1 stock split last week and a run-up of 25% over three months, QLogic ( QLGC) has been on the receiving end of three downgrades in as many business days.

For now, it looks like shares of the storage-gear maker may be due for a breather. But the stock has withstood the downgrades rather well, losing less ground this week than most companies in the enterprise storage sector, and there is some feeling on Wall Street that any slippage could signal a buying opportunity.

"Is it a little expensive now? It is," says J.W. Seligman analyst Sunil Wagle. "The risk/reward ratio is not in favor right at the moment."

Indeed, at Tuesday's close of $19.91, the stock is trading at about 29 times estimated 2006 earnings and 24 times 2007 earnings. Emulex ( ELX), the major competitor in its core business, is trading at 16 times 2006 earnings estimates and 15 times 2007 earnings, while Brocade ( BRCD), a competitor in the burgeoning market for storage switches, trades at 20 times 2006 EPS estimates and 18 times 2007 estimates, according to First Call.

Even so, Wagle hasn't soured on QLogic. "I'm waiting for it to weaken a bit so we can make a buy," he says. "It's an excellent company." Seligman does not have a current position in QLogic.

What do Wagle and other QLogic bulls like about the company? It's taking share from Emulex in its core market for host bus adapters, and perhaps nearly as significantly, it is moving carefully into new businesses, such as switches and high-performance computing, that should pay off in the future.

Last month, for example, QLogic agreed to acquire privately held PathScale for $109 million. The company sees the buy as the price for entering the emerging market for clustered computing, which relies on networks of inexpensive servers tied together with a technology known as Infiniband. Oracle ( ORCL), for example, uses clusters to speed -- and simplify -- the processing of large databases.

The PathScale acquisition should begin to generate revenue by the second half of fiscal 2007, which begins in April, said CEO H.K. Desai.

And last October, QLogic acquired chipmaker Troika Networks for $36.5 million in cash in a bid to acquire virtualization technology, which greatly improves the efficiency of storage servers.

During a recent appearance at an investment conference, Desai said he expects to continue making technology acquisitions but will stop short of following the example of EMC ( EMC) and other large storage firms that have entered the market for storage management software. "Doing so would place us into competition with our customers," he says.

Steve Berg, who follows QLogic for Punk Ziegel, likes the acquisition strategy. "It is clear that QLogic management has a vision of the future," he said, noting that the company believes the market for PathScale's products could reach $400 million in revenue in a few years.

Although Berg concedes that those arguing that QLogic is fully valued could have a point, he says the stock still has upside at current levels. QLogic's Tuesday closing price was 11% below his postsplit target price of $22.50. Berg rates the stock a buy; his company does not have a banking relationship with QLogic.

Andy McCullough, who follows storage for Credit Suisse, downgraded the company to hold late last week, saying that it had reached his $21 target. Even so, he saw no near-term threat to management's fourth-quarter guidance, which calls for year-over-year sales growth of about 14%.

He said "much of the recent optimism in the stock relates to QLogic's switch business, which increased 35% year over year and 52% in the December and September quarters respectively, coming off easy comparisons." He now forecasts growth of 19% for QLogic's switch business, roughly double the growth rate of the switch market as a whole. Credit Suisse has an investment-banking relationship with QLogic.

It's worth noting that switches carry a lower margin than adapters and will gradually pull the company's operating margin down to about 35% from their current 37%, according to Desai.

Kaufman Brothers analyst Shebly Seyrafi also downgraded the stock on valuation this week, but he too was still rather positive. He noted that QLogic is outgrowing Emulex, which is late to market with at least one key product, and said the tardy delivery could help QLogic gain more traction with EMC, a major customer of both companies.

However, weakness in shares of Emulex could pull down shares of QLogic, he said. His company does not have an investment-banking relationship with QLogic.

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