Moving with the Market
Friday, February 1, 2002
Storage product vendor qLogic grew its cash by about $40 million last quarter. Forget debates about what technology will prevail in storage, or new age management theory, $40 million more on the balance sheet at a time when most technology companies don’t have a P/E ratio is a strong statement.

It’s true that qLogic is in a sweet spot at the moment. The storage market that it addresses, with a broad product portfolio that covers everything from storage area networking (SAN) switches to controllers for disk drives and tape drives, is hot and is likely to remain on a consistent growth path for the next several years. The market for Fibre Channel technology alone is expected to grow 67 percent over the next five years.

CEO H.K. Desai has made the right technology bets, and signed up the right set of long-term customers. CFO Tom Anderson says simply, “If we stopped all design activity we’d still have revenue and sales for the next year or two.”

For all the CEOs sweating every quarter to scrounge up enough tough sales in a down market to prevent their stock from being crushed on Wall Street, that kind of cushion is almost depressing. Some companies have all the luck.

Technology Evolution

But qLogic has been around since the late 1980s, first as a subsidiary of Emulex until 1994, when it was spun out and became an independent public company. These days it competes with Emulex. Though qLogic is fortunate that it got into a lucrative market, it didn’t fall into its strong position by accident.

When asked about the fundamentals of engineering a company to be financially successful, H.K. Desai immediately puts investing in new technologies at the top of his list, and with good reason. When Desai joined qLogic in 1990, the company exclusively made controllers for disk drives. The boom and bust nature of the disk drive market was unsettling for Desai. He explains, “If we wanted to spin off, we needed to cover more segments, so we decided to cover the host side — SCSI technology.”

Since then qLogic’s market reach has grown significantly. In 1995, the company started investing in Fibre Channel technology, now the industry standard technology in storage networking. These days more than 70 percent of qLogic’s revenues come from the Fibre Channel market. It’s a case study in having the right product at the right time.

And today, as the storage market evolves to the tune of dozens of new startups and ambitious public companies like EMC, Brocade and Network Appliance, qLogic is carefully placing its bets for the future, investing in much-heralded new technology InfiniBand, and iSCSI, the next generation of SCSI technology.

Sure Bets

Adapting to new technologies can be a costly and challenging task for technology companies, with Wall Street craving short-term profitability, and expensive R&D necessary for survival in the rapidly-evolving market.

“Even if there is a short-term opportunity for extra revenue we ignore it.” Desai explains. His model for allocating his resources is a balance of restraint and adaptability. He makes the point that his company will never be wedded to any particular technical architecture or technological philosophy, always evolving its product focus where the revenues will be, wherever that ends up leading the company. One gets the sense that if in five years customers suddenly feel that storage networking isn’t practical (a highly unlikely development to be sure) Desai and qLogic will be ready with a whole new product focus in time for the shift in the market.

But it is a model of technological innovation that is also prudently executed. Besides not chasing short-term revenue opportunities, Desai also seems to very methodically place his bets.

“There are things which are obvious,” he submits. “If you look at Fibre Channel it’s going from one gigabit to two gigabit. So you have to invest to keep your current customer base. Then two gigabit goes to 10 gigabit.” So Desai will invest to develop products in accordance with these obvious trends. That’s the easy part.

But in the storage sector that qLogic plays in, nobody knows exactly how the adoption of InfiniBand, or new concepts like “storage virtualization,” will really play out over time. So how do you decide where to place your engineering dollars in a fiscally responsible way?

Desai talks to research analysts, and gets their perspective. He also talks to customers. But to add an extra level of insurance, qLogic actually works directly with customers to develop products in unproven markets. For example, Desai feels that Compaq has a good approach to the concept of virtualization. So qLogic is working jointly with Compaq to supply products that will go into the computer giant’s storage virtualization systems. As compared to blindly taking the advice of a few hype-driven industry analysts and technology experts, the Compaq partnership sounds like a pretty sure bet in terms of its potential for RoI and future orders. Desai is approaching InfiniBand the same way, working with Intel and startup Banderacom (which it has made a venture investment in).

The company’s customer model is obviously central to its revenue stability and success — qLogic has recorded 24 consecutive quarters of profitability. Ninety percent of the company’s revenues come from OEM customers. The development and deployment cycles on some of the customer products the company supplies components for are fairly long, and qLogic develops core pieces of technology with customers as the design phase is occurring. That translates into recurring revenue over the lifecycle of any given product.

Desai himself has always used a customer-based approach, where some of the risk of development and innovation is tempered by the involvement of a major customer. Early on, when qLogic was still relying on the disk drive market and needed to diversify, Desai, then VP of engineering, approached Sun Microsystems and said he could develop a host bus adapter (HBA) product for them. His pitch was successful, and with a customer sponsor the new project became “easy to sell within the company and to management,” Desai remembers. HBA products are now an important piece of qLogic’s product portfolio.

Frugal Fundamentals

“We are very frugal about what we do,” says Desai. But that’s clearly not just a question of not blowing money on extravagant office furniture, a la WebVan. For a company that is so focused on keeping its technology current — more than half of qLogic’s employees are on the engineering side — the process of allocating resources to product development is absolutely crucial to overall profitability.

CFO Anderson explains that much of the management of resources occurs on a project-by-project basis. “We have a product development planning process,” he explains. “As new programs are suggested, they go through a pretty rigorous set of reviews before we actually commit spending. Technology, marketing and sales people are at those meetings.”

Each project is closely monitored with an eye on company profitability, and with the company’s overall pre-set spending levels of 15 to 17 percent on R&D and 11 percent on sales and marketing in mind. Desai points out, “We watch every phase of the program and if we feel it isn’t the right investment then we just kill it.” He also adjusts spending on an ongoing basis, based on how much revenue is coming in.

Anderson highlights that this spending model is built into company processes and policy. “I hope that not too many things have to make it to my desk where I have to be a last wall of resistance,” he says.

As qLogic has grown, the company has had to institute much more formal processes and policy-making statements. Anderson advises younger companies to institute these processes also, “as long as they don’t kill the entrepreneurial spirit.”
He warns that some companies that are very profitable sometimes overlook formal processes, and when they get to certain stages in growth, that oversight becomes an inhibitor in terms of further growth.

He advises, “You have to plan your operations methodology well in advance. To the extent that you can devote a bit of time to do that early on you won’t find yourself in a crisis management mode.”

Acquisition Approach

Beyond the internal growth and technology evolution that qLogic has achieved, the company has grown through acquisitions. But again, Desai is careful to point out that these have been very focused. The company has done four acquisitions in the last four years.

“We only do technology acquisitions, we don’t acquire a company to acquire market share,” Desai explains. The company did make a substantial bet when it acquired SAN switching company Ancor Communications in 2000. The result is that qLogic now competes with storage industry heavyweight Brocade in the SAN switching market. It’s a market that’s a far cry from the company’s early disc controller business.

Desai assures that it was the right decision to invest in a technology that would open up a big addressable market. But acquisition is not a process without its short-term sacrifices. The fruits of the Ancor acquisition will likely only begin to manifest themselves during 2002, Desai projects, almost two years after the actual acquisition took place.

Desai points out the challenges of planning where to place your resources as a technology company. “You have to make the decision two years before you invest in order to see growth two years after that,” he says.

The company has had to deal with Wall Street’s short attention span. “When we acquired Ancor, Wall Street didn’t like it,” Desai remembers. “After a year the street has a feeling that we did the right thing. We didn’t look at the short term, we looked at the long term.”

Future Planning

Desai has been able to keep qLogic on the right track largely, it seems, by profitably structuring and managing the company’s engineering activities to match clear revenue opportunities. Of course it doesn’t hurt that the storage market has gone through the roof.

When asked about his future planning strategy, Desai jokes, “We are planning every week.” One thing that qLogic could be criticized for is the very reliance on a crucial set of OEM customers for almost all of its revenues (AMI, Compaq, Dell, EMC, Fujitsu, Hitachi, HP, IBM, Sony, Sun, etc.) that has made it so consistently successful. Is relying on each big customer for so much revenue a risky proposition in these volatile times in the high-tech industry?

Desai concedes, “This is a different world than it was five to seven years ago. Technologies change. Customers change their minds.” The way the technology industry operates is clearly fundamentally different today than it was in the mainframe-centric, more gradually evolving era of the 1980s and early 1990s.

Technology companies will need to be very savvy in the manner that they plan their core engineering and technology development — much more so than ever before. Though qLogic is riding high today, the future will only be bright if Desai and his team can impeccably balance short-term profitability and the right technology development. Of course that’s much easier as long as you’re selling lots of products.

Desai is confident that he knows where the storage market is headed now. He puts his faith in Fibre Channel as the primary growth engine over the next few years, despite what some ambitious startups are claiming about the superiority of newer flashier standards.

But iSCSI will grow, according to Desai because it expands the SAN market rather than taking market share away from Fibre Channel.

He explains, “If you want to extend the SAN over an IP infrastructure — for example if you have remote backup or remote mirroring, or disaster recovery — then you have to go over the IP infrastructure remotely, and iSCSI will be used initially there.” This is just one facet of a complex industry that qLogic services end to end.

Desai sums up his views on financial engineering with three points that should never be lost sight of as a technology company — “Investing in new technology, diversification, and staying cost competitive.” All of the internal points of execution to make these things happen seem so far to be perfectly synchronized within qLogic.

The company is excellently placed for another several quarters of solid profitability, but staying on top will take unrelenting focus on the future of the market, an absence of complacency and some well-timed technology development decisions. And, of course, some good fortune. si

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