Apologies if this has been posted before but interesting article from a month ago on why Mellanox Technologies is overvalued. I'm not long or short the stock but if you own the stock worth a read. I think company guidance today is clearly telling investors that growth at the previous rate won't continue. As an investor you have to ask yourself if the share price can justify the large multiple it trades at? As the stock looks down another 18 to 20% after hours it doesn't appear it can.
9.11.12
Posted by KerrisdaleCap at 7:09 am
We believe that shares of Mellanox Technologies, Ltd. (MLNX) are highly overvalued, not only because it is a semiconductor company operating in a small and technologically fast-changing niche trading at an absurdly high valuation, but, equally as important, the Intel CPU chip upgrade cycle which fueled its past few quarters of atypical growth is about to plateau, and then sharply decline.
We are short and own put options on shares of MLNX.
Investors apparently misunderstand the cyclical nature of Mellanox’s 56 GB/s “FDR” Infiniband business and have mistakenly extrapolated the recent uptick in Q1/Q2 growth into a long-term trend. As the upgrade cycle for Intel’s Romley CPU plays out, Mellanox’s FDR revenue could plateau in Q4 2012 and sharply reverse in 2013. When this occurs, the 50%+ quarter-over-quarter growth that investors have come to expect will be a thing of the past. As Mellanox’s lead product (54% of Q2 2012 revenue), FDR has been tailored specially for the Romley CPU system, meaning that FDR revenues probably tie very closely to Romley CPU shipments. Using this assumption and FDR revenue estimates, we estimate that quarter-on-quarter growth of the base business, excluding FDR-related revenue, was only 0.7% in Q2 2012. Non-existent growth in the core business hardly justifies the 50% share price bounce (from $65 to $95) that Mellanox experienced after its second quarter earnings release, let alone the further increase to $110 in the past two months.
Unfortunately for most investors, the cyclical nature of the tech hardware business is rarely modeled by analysts, who prefer straight-line forecasts and sky-high, AMZN-like valuation multiples for whichever business is in vogue at the time. But while they lavish Mellanox with unbounded praise in their qualitative analysis, most analysts have actually modeled a material growth slowdown in 2013. As such, we believe that investors in MLNX are currently playing with fire and would be wise to avoid shares at the current astronomical valuation level.
As for the notion that MLNX may be acquired, the idea of an acquisition is preposterous at prices anywhere close to the current trading levels. A scan of the tech landscape tells us that of the few strategic buyers that might exist, most couldn’t afford MLNX’s current valuation (such as ELX, QLGC, HPQ). Those that can would prefer higher-margin branded products and services (ORCL and IBM), or have already made their Infiniband investments (INTC). Others would likely allocate internal resources to create a next-generation rival product instead of overpaying for a risky acquisition (BCOM). Since Infiniband remains a small niche market confined to high-end supercomputing, no rational buyer would consider acquiring MLNX for a $5+ billion valuation, in our opinion.
Notwithstanding its current share price bubble, we believe that Mellanox has built itself a niche business and achieved a big win through the Romley upgrade cycle. But high-speed computing is a cutthroat space and Mellanox still faces competitive risks from all sides (e.g. Intel’s Infiniband and Cray interconnect, 40GB/s low-latency Ethernet, etc.). Since high-tech hardware is such a cyclical, competitive space, almost all peer companies trade below 10x Forward EV/EBITDA and many trade below 5x. Mellanox’s 28x FY12E EBITDA is in another stratosphere, and as frequently occurs in the tech space, we expect shares to sharply snap back at the slightest earnings waver. Make no mistake about it: this is a momentum-driven growth stock and its shares can only levitate at these prices while the company delivers spectacular growth numbers. Even Mellanox can only defy gravity for so long.
THE ROMLEY UPGRADE CYCLE HAS DRIVEN SHORT-TERM GROWTH
Mellanox provides premium Infiniband chips used in high-performance computer (“HPC”) clusters. Infiniband is a hardware interconnection tool that allows stacks of databases, servers, and computers to ‘talk’ to one another. While most commercial servers are perfectly content with 1G/s or 10G/s Ethernet interconnection, a small niche of specialized HPC clusters prefer the higher speed and low latency of Infiniband, of which MLNX is the leading supplier, and are willing to pay the higher prices associated with it. In particular, Intel’s Romley CPU core, which was released in 1Q 2012, included Mellanox’s products as among its preferred interconnection tools; therefore, as has been the case over the last few quarters, each time that an HPC cluster upgrades to the Romley core, many will purchase the FDR interconnectors as well.
