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Bull of the Day: Mellanox (MLNX)

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Mellanox Technologies (MLNX - Free Report) is a $4 billion provider of essential semiconductor-based, interconnect products to world-class server, storage, and infrastructure OEMs servicing Fortune 500 data centers, the world's most powerful supercomputers, and mission critical embedded applications.
Mellanox is scheduled to report Q2 earnings after the close this afternoon and given recent EPS estimate bumps by analysts we should be expecting an upside earnings surprise. The quantitative screen known as the Zacks Earnings ESP (Expected Surprise Prediction) has calculated the potential for an approximate 4% beat on the bottom line. The company delivered an 18% positive surprise for Q1.
I like this player in the fast-growing HPC (high-performance computing)/hyper-scale data center space so much, I went and bought the stock last week. The company's Virtual Protocol Interconnect enables standard communication protocols to operate over any converged network (InfiniBand, Ethernet, Data Center Ethernet) with the same software solution. 
The TOP 500 Supercomputers in the World
What put Mellanox on my radar, besides the Zacks Rank, was the semi-annual TOP500 Supercomputer List which was published June 25. This key industry ranking found that an IBM-built (IBM - Free Report) supercomputer called SUMMIT, now running at the Department of Energy’s Oak Ridge National Laboratory, captured the number one spot with a performance of 122.3 petaflops on High Performance Linpack (HPL), the TOP500 List benchmark.
SUMMIT has 4,356 nodes, each one equipped with two 22-core IBM Power9 CPUs and six NVIDIA (NVDA - Free Report) Tesla V100 GPUs. The nodes are linked together with a Mellanox dual-rail EDR InfiniBand network that can run bandwidth of 100G/sec.
What's a FLOP?
A "petaflop" is the ability of a computer to do one quadrillion floating point operations per second (1,000 million million). For comparison's sake, the Microsoft (MSFT - Free Report) Xbox One X gaming system has 6 "teraflops" that allow it to perform 6 trillion floating point operations per second.  
So each SUMMIT is roughly equivalent to the processing power of over 20,383 Xbox One X consoles (assuming they were somehow connected).
After the TOP500 list was released, analysts at Stifel Nicolaus noted the importance of the transition toward higher bandwidth networks within the top supercomputers:
Now that Ethernet is available at similar performance levels as InfiniBand and OmniPath, Ethernet adoption rate is accelerating. Not surprising to us is that Mellanox provides all of the +25Gb/s Ethernet networks on the list. Accelerator use continues to increase with NVIDIA's GPUs dominating and Intel's Xeon Phi falling off the pace. Meanwhile, Intel's ((INTC - Free Report) ) Xeon CPUs are used in 95% of the systems on the list. We consider TOP500 Supercomputer list as important for setting the trends for future data center computer system architectures.
To get an idea of how this industry growth is impacting Mellanox, here's a look at the Detailed Estimates page on
I've circled the annual revenue growth in the top half and the EPS growth in the bottom half of the tables. Clearly, this blistering pace will be nearly impossible to maintain into next year. But maybe solid, mid-teens double-digits are still on the horizon.
And that's why the company guidance this week will be so critical in fine-tuning those analyst projections.
Mellanox and Starboard: A Forced Marriage With Hope
Despite the strong growth story here, there has also been another story for investors to deal with concerning the increasing activism of a large shareholder.
In November 2017, activist investor Starboard Value LP disclosed a nearly 11% stake in Mellanox shares.
Then in January, the new largest investor, with assets under management of over $6 billion, went on the attack telling the company in a letter that Mellanox Technologies’ 2018 growth targets were “not nearly enough” and rely too much on revenue growth.
At the time, Mellanox was forecasting low to mid-teen percentage revenue growth this year and Starboard sought to elect new directors of their choosing to the company's board.
In March Mellanox and Starboard clashed over the company's board of directors election structure and its upcoming annual meeting. Mellanox sent shareholders a letter asking for votes in favor of a plurality voting standard in the event of a contested election and the use of universal proxy cards. The company wanted to hold an extraordinary general meeting (EGM) to deal with these issues. 
Mellanox’s board had a majority voting structure, which means that the board could have some vacancies if all candidates don't get enough votes. The majority-elected directors would then fill the vacancies. Plurality voting would have all of the board members elected by the shareholders. 
This company response followed Starboard's attempt to nominate a full slate of directors to the Mellanox board. 
Working It Out 
But by June, the two sides were nearing a cooperative deal over the composition of the board, which would help avoid a proxy fight at the shareholder meeting on July 25.
Finally, on June 19 Mellanox and Starboard struck a settlement to appoint new board members and name a director if the company fails to meet certain operating goals.
Mellanox announced that three newcomers will join its 11-member board, negotiating a compromise five months after Starboard said it planned to oust all sitting directors.
The company's revelation that the hedge fund will be allowed to appoint a direct representative to the board if certain performance thresholds are not met, was seen by some as an aggressive concession.
Shares initially spiked to new highs above $90, but then sold off the next three days.
Analysts and Investors Give the Thumbs-Up
Here was reaction from two investment banks on June 20, courtesy of
Stifel Nicolaus analyst Kevin Cassidy said he views Mellanox's director agreement with Starboard as a "significant win" for investors, stating that the addition of successful leaders in the semiconductor industry to the board is important for sustained growth. Mellanox management agreeing to higher operating margin expansion targets is "testimony to management's confidence in new product traction," added the analyst, who keeps a Buy rating and $111 price target on the stock. 
Piper Jaffray analyst James Fish views the mutual agreement announced by Mellanox Technologies and Starboard as a "win-win" for shareholders. If Mellanox does not execute on its operational plan, which is above expectations, Starboard will likely become directly involved and potentially install someone to execute on the plan, Fish tells investors in a research note. The analyst continues to recommend Mellanox shares with an Overweight rating and $100 price target.
Getting the Balance Right
Then on July 12 we learned from an SEC 13D filing that Starboard reduced their MLNX holdings by about 890,000 to 4.57 million shares early this month, moving from a 10.5% stake to an 8.6% position in the company. Starboard indicated the sales were designed to effectuate a rebalancing of its portfolio in light of the significant appreciation in the company's stock price since filing its initial 13D in November 2017.
The hedge fund intends to remain a large shareholder of the company and to monitor its progress towards the minimum performance thresholds included in the settlement agreement as well as the company's public commitment to drive profitable growth.
The knee-jerk reaction in the stock on this news was a quick plunge below $80 and a same-day recovery that was just as abrupt. This has kept the stock's closing price above the June swing lows near $82.
For investors taking a position in MLNX in the low-to-mid $80s, I see risk/reward of at least 2:1 in their favor, with 10% downside risk to $75 (which should be good technical support) and 20% upside potential to $100.
We'll know a lot more after tonight's report.
Disclosure: I own shares of MLNX for the Zacks TAZR Trader portfolio.
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