Mellanox Technologies ($MLNX): More on the Short Thesis

We believe that shares of Mellanox Technologies, Ltd. (NASDAQ: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 Mellanox Technologies, Ltd. (NASDAQ: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,, Inc. (NASDAQ: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 Mellanox Technologies, Ltd. (NASDAQ: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 Emulex Corporation (NYSE:ELX, QLGC) QLogic Corporation (NASDAQ:QLGC), Hewlett-Packard Company (NYSE:HPQ)). Those that can would prefer higher-margin branded products and services (Oracle Corporation (NASDAQ:ORCL) and International Business Machines Corp. (NYSE: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.


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 Corporation (NASDAQ:INTC) 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.

We believe that investors do not fully appreciate the cyclicality of Mellanox’s business. Intel’s supercomputer processing units, the industry standard, undergo predictable product cycles. Sales will ramp for three to four quarters before plateauing for a quarter or two. CPU motherboard sales then fall sharply ahead of a new product launch since customers won’t pay top-dollar for soon-to-be outdated technology.  Because Mellanox’s FDR Infiniband chips are usually purchased alongside high-end CPUs, Mellanox’s sales cycle should track closely to the Romley cycle.  In fact, since much of Mellanox’s FDR customers represent the highest-end of the supercomputing market, we would actually expect the FDR cycle to have a shorter duration than the overall Romley cycle.  This is because those willing to pay the extra costs for FDR over Ethernet were probably also the first in line for the upgrade in Q1 and Q2 2012.  Therefore, we expect that Mellanox’s temporary Romley-related uplift will be gone by Q4 2012 or Q1 2013, potentially eliminating up to half of Mellanox’s revenuein the quarters ahead of the next server CPU launch.

Since most analysts have merely assumed straight-line quarter-over-quarter growth, we believe that Mellanox could materially miss estimates during Q4 2012 or FY 2013 earnings reports.

Below is a chart of Intel’s Romley server upgrade trajectory, as compared with historical high-end HPC server cycles.

As we can see, the Romley server ramp will probably plateau within the next few quarters. Then Romley purchases should plummet.

The most recent 10Q discloses FDR-related and non-FDR-related revenue in Q1 2012 and Q2 2012. Growth in non-FDR related revenue was essentially flat in Q2 2012 compared to Q1.  As previously discussed, a majority of FDR revenue is tied to the Romley CPU system.

Deutsche Bank acknowledges the impact of the Romley release by stating, “Anticipation of the Romley release led to some pent-up demand for Mellanox’s products, which at least partly explains the 111% YoY increase in revenues in Q2 2012” (DB September 4th, 2012 Research Report).  Even more worryingly for Mellanox, Intel has indicated that Romley uptake may have spiked more quickly than previous cycles. INTC stated that “one month after launch, Romley has shipped nearly twice the volume of Nehalem at the same point in its ramp” (Q1 2012 Earnings Call).

The chart below shows revenue estimates using Wall Street consensus. We’ve also overlaid grey circles to represent how we expect the Romley product cycle to play out. Notice that analysts only have a 3% slowdown forecasted for Q1 2013.

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