Have We Seen The Worst For Mellanox?

By Stephen D. Simpson, CFA | January 04, 2013 AAA

In a year that was generally pretty tough for most semiconductor-related stocks, Mellanox (Nasdaq:MLNX) spent most of the year as a notable exception, with strong data center/storage demand feeding torrid growth. With that growth high valuations and high expectations came, but the stock spent most of the last quarter of 2012 selling off.

Now, the other shoe has dropped. Mellanox not only warned the Street that fourth quarter results would come in below expectations (the first-ever warning), but the magnitude of the miss was startling. With the shares crushed in aftermarket trading, the debate now is whether this is an overreaction to a small stumble from a high-growth company, or whether this marks the beginning of some serious challenges to this highly-valued stock.

Top Investment Trends For 2013: We go over a few investment trends for you to think about for 2013.

A Big Miss ... or Is It?
Mellanox announced after the close on Wednesday that fourth quarter revenue came in substantially lower than management expected. Instead of the approximately $148 million in revenue that management had looked for, the actual number seems closer to $120 million; in percentage terms, that marks a 23% sequential decline versus an expected decline of 6%.

The makeup of the miss is interesting, though. It sounds like a sizable percentage (about 70%) of the revenue miss can be tied to a vendor component issue (technical cabling) that impaired FDR 56Gb/s InfiniBand shipments. The remainder seems tied to weak market conditions (more on this in a moment).

Interestingly, management maintained its guidance for gross margin and operating expenses. It's not normal for chip companies to post sizable revenue misses and still maintain margins, so this is an interesting occurrence for Mellanox.

SEE: Can Earnings Guidance Accurately Predict The Future?

A Pause, a Dip or a Cliff?
The fortunes of Mellanox are closely tied to the data center/data storage market, and that market has been weakening for a little while now. Major customers like Hewlett-Packard (NYSE:HPQ) and IBM (NYSE:IBM) have been reporting weaker data center end markets, and fears are mounting that EMC (NYSE:EMC) is setting up for a miss-and-lower fourth quarter.

"Big Data" has been such a common topic in tech that it has almost grown to be a cliché. Now it looks like demand is tapering off. The question, though, is whether customer demand has been sated or whether this is just a slowdown tied to macroeconomic concerns. Most of the demand drivers for storage still look to be in place, but investors have to be wary of the risks of falling into the "it's different this time" trap.

As it pertains to Mellanox, there are still valid drivers for 2013, including RoCE and 10G switching products. Oracle (Nasdaq:ORCL) has also been pretty optimistic with its guidance and expectations for Exadata, which is also a customer for Mellanox. What's more, it doesn't seem like Intel (Nasdaq:INTC) is really taking away much business so far, and if the "it's only a pause/dip" thesis on Big Data is true, the company should see a rebound in the second half of the year.

SEE: The Industry Handbook: The Semiconductor Industry

The Bottom Line
The good and bad news of Mellanox still revolves around growth and valuation. The stock has come down well off its highs, but that's not to say it's a particularly cheap stock yet, as it still trades at an EV/revenue multiple of close to five times.

What's more, even an assumption of more than a 20% compound annual growth rate in free cash flow (FCF) for a decade doesn't drive a remarkable price target. If Mellanox can grow revenue at a high teens rate and produce strong FCF margins in the 20% range, the resulting mid-20% range FCF growth only points to a fair value in the low $60s. While this may be the best chance investors will have in the near term of buying these shares at something like a reasonable valuation, investors should also note that this is a risky stock that still carries very high performance expectations.

At the time of writing, Stephen D. Simpson owned shares of EMC since 2012.

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