Mellanox Hanging Out In The Right Places

By Stephen D. Simpson, CFA | March 12, 2012 AAA

Want to play Big Data?

How about Web 2.0?

Oh, and what about Cloud?

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You can get all that and more with Mellanox Technologies (Nasdaq:MLNX). This semiconductor company continues to log excellent growth with leading market share in high-performance interconnects. While the entry of Intel (Nasdaq:INTC) into its core market is clearly a threat, aggressive investors may yet do well with this name.

Winning with InfiniBand
I've made the "to InfiniBand and beyond" pun before, but the fact remains that Mellanox continues to log excellent growth with its InfiniBand products. With market-leading products (including a 56 GB/s product), Mellanox continues to be an in-demand partner for major OEMs like IBM (NYSE:IBM), Hewlett-Packard (NYSE:HPQ) and EMC (NYSE:EMC) as companies look to roll out ever-faster and more powerful solutions for networking and storage.

Perhaps some proof of Mellanox's strength is evident in the fact that its rival QLogic (Nasdaq:QLGC) decided to quit, selling its InfiniBand assets to Intel. Market share estimates vary (depending on how the true market is defined), but with 60-80%+ share, Mellanox is clearly the leader. Moreover, it looks as though Mellanox was at least one generation ahead of QLogic - meaning that Intel has a lot of work to do to close the gap.

I don't think investors should fret overly much about Intel's entry. For starters, I would argue that it validates the legitimacy of the market opportunity. Second, competition tends to drive good companies forward, while monopoly status leads to indifferent R&D and sales efforts. (For related reading, see A History Of U.S. Monopolies.)

Expanding the Footprint
Mellanox is not just about InfiniBand. The acquisition of Voltaire gave the company a more end-to-end product suite and the company's 40GBE Ethernet-based interconnect seems to be selling well and grabbing share.

These Ethernet efforts will be interesting to watch. On one hand, Mellanox is marching into the teeth of competitors like Broadcom (Nasdaq:BRCM), Intel and, to a lesser extent, Brocade (Nasdaq:BRCD) and Marvel (Nasdaq:MRVL). On the other hand, it's a bigger market and the revenue to be gained with market-leading technology would be considerable.

An Alluring Story
There's a lot about Mellanox that makes this an intriguing growth story. High bandwidth transmission and low latency is increasingly a must-have in enterprise data centers and high-performance computing, and something of a choke-point for the aspirations of "Big Data," Web 2.0 and Cloud advocates. Facilitating those markets could make Mellanox quite popular with major tech OEMs and propel revenue, cash flow and market valuation quite a bit higher.

Of course, any good story is going to draw expectations and competition. The valuation on Mellanox is indeed high and rivals like Intel and Broadcom have the same sort of aspirations for growth as Mellanox. What's more, it would stand to reason that Mellanox is vulnerable to a general slowdown in enterprise IT spending; while the company still has substantial organic growth potential, there's only so far that story can go without solid underlying market expansion.

The Bottom Line
It's tough to establish the thesis that Mellanox is significantly undervalued. Not only is the current EV/revenue multiple high in its own right (over 4.5 times), but those few names with higher multiples either offer much better profitability (like Linear (Nasdaq:LLTC)) or established market dominance (like Qualcomm (Nasdaq:QCOM)). Then again, Cavium (Nasdaq:CAVM) is a broadly similar networking chip company with similarly high multiples. (For related reading, How To Use The P/E Ratio And PEG To Tell A Stock's Future.)

Look at the history of semiconductor growth stories like Broadcom, Qualcomm and Silicon Labs, and you will see that compound free cash flow growth of better than 20% over a decade is indeed possible in the chip space. That's a lofty goal for any company, but Mellanox could offer that sort of long-term growth if things go right.

High expectations leave little room for disappointment and it's almost a certainty that Mellanox will deliver some harrowing drops along the way. That said, growth seldom comes without risk and Mellanox is, on balance, a very interesting growth stock today.

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

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