Tech is perennially frustrating for value-driven investors, but Mellanox (Nasdaq:MLNX) is taking that to a new level. While the shares have long looked appealing on the basis of the growth potential, valuation has looked aggressive unless an investor was willing to make pretty outrageous growth estimates. As it turns out, maybe "outrageous" was actually conservative, as this Infiniband adapter specialist boosted revenue guidance for the next quarter by a whopping 50%.
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Second Quarter Coils the Spring ...
Mellanox also happened to have a pretty good second quarter. Revenue beat expectations by a small margin, climbing 111% from last year and 50% from the first quarter. Adoption of 56Gb/s Infiniband is proving to be a major driver, as sales in this category jumped 162% from the first quarter. Ethernet sales also resumed a growth trajectory, up about 5% from the prior quarter.
With higher sales, Mellanox is seeing significant operating leverage. Gross margin rose about a point and a half from the first quarter, while operating income more than doubled from the first quarter. That was even with a 30% sequential increase in research and development spending (and, curiously, a sequential increase in SG&A of just 25%).
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... And Third Quarter Expectations Head Skyward
Hands down, the biggest surprise coming out of Mellanox's quarter was the robust guidance for the next quarter. Where analysts had projected a sequential decline of almost 20%, management guided instead to a 12% sequential growth - which may not sound huge until you realize that translates into a number that is 50% higher than the prior average of analysts' estimates.
It's also curious that Mellanox is so confident about growth at a time when major customers like Hewlett-Packard (NYSE:HPQ) and IBM (NYSE:IBM) are seeing pretty sluggish hardware demand (and these companies represented about 30 and 19% of sales this quarter, respectively). While some of the growth is coming from better sales of high-end Exadata and Exalogic systems from Oracle (Nasdaq:ORCL) (which owns nearly 10% of Mellanox), it is also due to deeper penetration and substitution from Mellanox products - in other words, while top-line hardware growth may not look so impressive at IBM and HP, Mellanox is getting a bigger share of what's sold and is placed in the faster-growing segments (which gets averaged out by slower-growing categories at its customers).
Markets Vs. Competition
It looks like Mellanox is starting to see real traction in data centers and is moving further into storage products. Given the growth outlook for companies like EMC (NYSE:EMC), cloud and "Big Data," that bodes well for Mellanox.
But what about Intel (Nasdaq:INTC)? Although Mellanox is probably a year or two ahead of Intel, Intel's desire to play a major role in data centers means that it won't be content to play second-fiddle to Mellanox. The question I have is about how many things Intel can do well at once - the company really has no serious competition in PCs, but badly wants to close the gap with ARM Holdings (Nasdaq:ARMH) and supplant it in smartphones and tablets. While I do believe Intel's in-house manufacturing capabilities give it some inherent advantages, I wonder if Intel can simultaneously chase down ARM and Mellanox.
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The Bottom Line
I'm not all that bitter about missing the boat on Mellanox; I would have loved to have seen this sort of growth potential in the making and gotten in, but I don't believe investors can win long-term by just ignoring valuation and chasing growth at any price.
Even with substantially higher estimates for Mellanox's growth, these shares are still not looking all that cheap. Clearly, another beat-and-raise on the scale of this quarter would send those estimates straight into the trashcan and spike the shares further. For investors who love growth and can handle the outsized risks of being wrong, these shares are likely to at least be exciting over the next few quarters.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.