2HRS2GO: QLogic puts on its own Ancor spin

As far as I can tell, these are the reasons cited by QLogic (Nasdaq: QLGC) shareholders lambasting the Ancor Communications (Nasdaq: ANCR) deal:

• QLogic overpaid.
• Ancor is overrated.
• The purchase will strain relations between QLogic and the runaway market share leader for fibre channel switches, Brocade Communications (Nasdaq: BRCD).

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Shares of QLogic have fallen more than 37 percent since the company unveiled a plan to buy Ancor, the number two player in fibre channel switches. QLogic, whose I/O boards connect computers to storage devices and networks, says it wants to offer customers a broader selection of products for corporate storage networks. Sounds like a hardware suite approach.

Wall Street wants no part of the idea, especially at a price that would increase QLogic's current number of shares outstanding by more than 20 percent. That kind of dilution is tough for shareholders to swallow in any case, and especially for a company that fell short of analyst forecasts as recently as December and, according to at least one analyst, lost a bit of market share to its biggest rival.

Media reports quote Brocade CEO Gregory Reyes saying his company will stop sharing certain data with QLogic to avoid giving proprietary information to a competitor. He also questioned the point of merging a host bus adapter company like QLogic with a switch maker, because there are few cost-cutting options and little, if any, way to use one product to sell the other. Brocade believes data storage vendors want the best products, regardless of who might be selling them.

To no one's surprise, QLogic disputes that. Although some customers want "dual sourcing", others prefer a one-stop shop, says Tom Anderson, QLogic's chief financial officer.

"Sun Microsystems (Nasdaq: SUNW) buys I/O chips from us and switches from Ancor, and they love this deal," Anderson says. "One of the big synergies in this transaction, we believe, is that with each other, we can access customers that neither of could get on our own."

Maybe that wasn't the best example he could have given, since Sun's lethargy in rolling out products with Ancor switches reportedly contributed to Ancor's fourth quarter EPS disappointment. But even with companies who prefer best-of-breed, you have to wonder if QLogic will be hurt all that much.

Even Reyes says Brocade will keep working with QLogic. After all, QLogic ships more host bus adapters than anyone else. Did Intel (Nasdaq: INTC) cut off IBM (NYSE: IBM) when Big Blue made Cyrix chips? No.

As long as QLogic's core business continues growing strongly, relationships with other vendors will take care of themselves. Major players in related technology markets can't help but maintain ties with each other.

Brocade's criticism of the Ancor purchase won't directly hurt QLogic's revenue. "There's a misconception there," Anderson says. "We don't sell products to Brocade."

And Reyes' comments are at least partly self-serving. When your company has 90 percent of the fibre channel switch market, you're going to scoff at any attempts by your competitors to break into that.

The real risk to this deal -- particularly because the acquired entity would continue to run itself -- is that Ancor might turn out to be a weak business.

Although its top line has grown impressively on a percentage basis, the revenue is coming off a very small base. Short sellers, who look for companies with questionable fundamentals, loved Ancor until now; as of a month ago, more than six percent of the company's outstanding float was being shorted, according to Market Guide.

On the other hand, it's not like QLogic is paying cash for Ancor. It's an all-stock deal, basically the equivalent of play money. Earnings per share may take a hit (QLogic says they won't) but the balance sheet doesn't get hurt at all. QLogic predicts the deal will be EPS neutral this year, and will add to earnings starting next year.

So this deal doesn't change QLogic's host bus adapter business, which is what attracted QLogic investors during the stock's run-up.

And it could add a lot to the bottom line in the long run, assuming Ancor can maintain its torrid growth rate. No doubt that will be the sales pitch during tomorrow's quarterly conference call for QLogic.

In the near term, that call will determine whether this stock bounces or stays down. 22GO>