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Bull of the Day: Mellanox Technologies (MLNX)

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I last wrote about Mellanox Technologies (MLNX - Free Report) as the Bull of the Day on July 17 before they reported their Q2 results, which included a 16% EPS beat, a 1.2% top line beat and raised guidance.
In short, this $4 billion provider of essential semiconductor-based, interconnect products to world-class server, storage, and data centers customers delivered the coveted "trifecta" in its quarterly performance.
Record quarterly revenue of $268.5 million was up 7% sequentially and 27% year-over-year. The company's ethernet revenue was up 81%, and ethernet switch revenue +114% annually.
Mellanox gave improved guidance for Q3 with revenue in a range of $270-$280 million, vs the consensus of $270 million. The company sees Q3 gross margins of 68.5%-69.5%.
Accordingly Mellanox raised this year's revenue projection to $1.065-$1.085 billion from $1.05-$1.07 billion. The company sees full-year gross margins at 68.5%-69.5%. Gross margins were lighter year over year with Q2 GM at 61.4% vs. 65.5% last year, so I think this guide for the full year helps a lot.
This paragraph in the press release from the CEO, Eyal Waldman, sums up the current state of business pretty well...
"We continue to see strong traction with our 25 gigabit per second and above solutions as they become the preferred solution of choice in hyperscale, cloud, high performance computing, artificial intelligence, storage, financial services and other markets across the globe. Our Ethernet revenue grew 81 percent year-over-year driven by network adapter and switch growth with hyperscale and OEM customers. We are proud to see our InfiniBand solutions accelerate the world's top three and four of the top five supercomputers, as seen in the recently published TOP500 supercomputers list. Our performance in the second quarter further shows the benefit of our investment in diversifying our revenue base and the operational focus that is driving our higher profitability."
The TOP 500 Supercomputers in the World
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 in July before earnings. 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.
In my July article, here's what I said about the TOP500...
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 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 which shows the rise in profit projections by analysts since the report...
Deep Learning and AI Are Changing the World Fast
As I type this on Monday afternoon, NVIDIA CEO Jensen Huang is on stage at Gamescom -- the world’s largest gaming expo -- being held this year in Cologne, Germany. He's wowing the gamer/developer crowd with amazing views, stats and demos on NVIDIA's record-breaking new "deep learning" architecture called Turing, featuring RTX image and light reconstruction/simulation powers that computers teach themselves. 
In my over-simplification of what this technology represents, it's like bringing Hollywood, photo-realistic CGI capabilities, that take months of creation and rendering time, to video gaming in real time.
“Turing opens up a new golden age of gaming, with realism only possible with ray tracing, which most people thought was still a decade away,” said the founder of NVIDIA. “The breakthrough is a hybrid rendering model that boosts today’s computer graphics with the addition of lightning-fast ray-tracing acceleration and AI. RTX is going to define a new look for computer graphics. Once you see an RTX game, you can’t go back.”
Jensen is certainly passionate about the hard work his company has put into GPU (graphical processing unit) semiconductor technologies and all the amazing visual performance and speed it brings to the world of gaming.
But he is also very excited about what else he and his teams learn as the continue to push the limits of the possible in machine learning and deep learning (i.e., advance neural networks with many layers of temporal processing).
He sums it up with an idea that should blow your mind: deep learning will enable computers to write their own software (my paraphrase).
And it's fascinating to think that the $100 billion gaming industry is responsible for driving this innovation in deep learning and AI. For more on that industry of serious fun, check out my podcast where I break it all down with my Millennial-gamer colleague, Ryan McQueeney...
By the way, Intel (INTC - Free Report) doesn't plan to be left out of these powerful trends either. In a bid to add robust deep learning capabilities across various operating verticals, Intel recently acquired Vertex.AI, a Seattle, WA-based startup. Per the home page of Vertex.AI, the private company will join Intel’s Artificial Intelligence Products Group.
The product roll-outs this week from NVIDIA are definitely exciting for both gamers and AI researchers. And I share this because it's also great news for Mellanox as they supply the wiring, switches and connective guts to datacenters and supercomputers that enterprise buyers of new NVDA technology will need to have to run it at scale.
NVDA shares fell after earnings last week and staged a rally today off of $240 during Jensen's keynote, a level where I always to tell my group to buy below. But MLNX shares have struggled more. Let's look at some possible reasons why to see if investors should be concerned, or adding to their position.
Analysts Like the Growth Trends, But Investors Are Sidelined
Since Mellanox's stellar report the stock is down 7%, while the industry barometer, the Philadelphia Semiconductor Index (SOX) is down over 3%, indicative of a summer lull in Tech stocks in general.
Besides a general sentiment that activist hedge fund Starboard could be interested in selling more of their large stake (see my July report for details), I think the other dark cloud was a big broadside for datacenter bellwether Broadcom (AVGO - Free Report) . Goldman Sachs downgraded AVGO shares from Buy to Neutral and slashed their PT from $300 to $220 that week.
And there is also the possibility that the company guidance wasn't great enough.
But several investment banks remain positive, raising those estimates you see above after they plugged the higher gross margin numbers into their models. Here was a sample of actions and reactions...
Stifel Nicolaus: Revenue Growth and Operating Margin Expansion Continues; Reiterate Buy and PT $111
Piper Jaffray: Ethernet Adapter Cycle Remains in Early Innings; Overweight & Raising PT to $110
KeyBanc: Strong Revenue Growth Driven by Ethernet, While Margin Expansion Continues
Other smaller banks like DA Davidson, Benchmark and Loop Capital all raised their PTs to the high end of the range with these targets: $115, $120, $125 respectively.
And here was another big bank that commented specifically on the Starboard activism and stake...
Barclays raised its price target on Mellanox Technologies to $107 from $103 while keeping its Overweight rating, after lowering its target multiple to 18x from 20x as the product cycle accelerates.
"Based on the strong outlook and the agreement with Starboard that keeps OM [operating margins] in focus, we see the current share price as a good entry point," analyst Joseph Wolf said in a note.
"We do not see Starboard's recent trimming of its position, given the high return already achieved, as any sort of signal for fundamental investors."
While I obviously agree with Barclays on Starboard, I can't help but think that this is part the negative sentiment right now.
Because the quarter and outlook were strong enough to make the valuation more attractive in the company's "hot" markets.
So much so that Barclays could lower their target multiple to 18X as they shifted their earnings view out to 2020 where they see the company earning nearly $6.
Bottom line on MLNX: Trading at 16X a blend of this year and next's EPS projections, the stock is neither cheap nor expensive -- unless you compare that P/E to its sales growth of greater than 20%. And after NVIDIA reported last week that its datacenter business was up 83% year-over-year, I am encouraged that the trends driving Mellanox growth will continue into 2019.
Disclosure: I own shares of MLNX and NVDA for the Zacks TAZR Trader portfolio.
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