Mellanox More Than Biding Its Time Into The Nvidia Deal Close

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Summary

With Chinese approval of the proposed Nvidia (NVDA) acquisition of Mellanox (MLNX) still an “any day now” event, there’s been no new developments since my last update for arguably the most important driver of Mellanox shares now. I had hoped that approval would come before the Chinese New Year, but that didn’t happen, and with the added issue of the coronavirus outbreak, Mellanox and Nvidia shareholders may have to sit tight a little while longer.

I continue to believe that there’s little long-term risk in playing this opportunity. Yes, I expect Mellanox shares would be weak in the immediate aftermath of a deal cancellation, but with the strength seen in Mellanox’s business lately, investors look likely to come out ahead either way.

A Strong Close To A Good Year

With the deal completion looming, Mellanox is no longer hosting investor conference calls or offering slide presentations with earnings, and the information is limited to a press release somewhat lacking in detail regarding revenue. Those details should be available in a month or so when the company files its 10-K. Working with what Mellanox offered, though, it’s clear the company had a very strong fourth quarter.

Revenue rose 31% yoy and 13% qoq, well above (14%) the sell-side average estimate for the quarter. Growth was fairly balanced, at least on a sequential basis, with particularly surprising performance in the InfiniBand business. Revenue here rose 18% yoy and 19% qoq, with the company spotlighting strong performance in 200G. The performance of the Ethernet business requires some estimation (and there’s usually an “other” quarterly contribution), but growth appeared to be on the order of 48% yoy and 11% qoq, with switches up more than 25% qoq, suggesting better than 100% yoy growth.

Gross margin improved slightly on a year-over-year basis, up 10bp and about a point on a sequential basis, beating expectations by 240bp. Operating income rose 50% yoy and 24% qoq, driving 400bp of yoy margin expansion (and 270bp qoq) and beating expectations by 46%. Free cash flow also came in stronger than I expected for the full year.

Not surprisingly, there was no forward guidance from the company, and I expect that sell-side estimate revisions will await the publication of the 10-K.

Still Strongly Leveraged To Healthy Long-Term Capex Trends

We’re still relatively early in the reporting cycle, but it looks like hyperscale capex spending may have slowed to more or less flat year over year. Microsoft (MSFT) reported stronger-than-expected 17% yoy growth in fourth-quarter capex (and 64% revenue growth from Azure), but Facebook (FB) reported a 6% yoy decline in cash capex (15% below consensus), and Apple’s (AAPL) capex was likewise significantly below expectations. Amazon (AMZN) reports in a few hours (as of this writing), while Alphabet (GOOGL) reports in the first week of February.

While the fourth quarter’s overall spending levels may have been less than expected, customer mix matters, and Mellanox is leveraged to Microsoft, particularly with 50G Ethernet. Microsoft guided to healthy capex growth (or at least sequential growth) in the first quarter of 2020, and Facebook likewise guided to 15% yoy growth in 2020. Third-party research firm Dell’Oro has speculated that much of Facebook’s 2019 spending was targeted at facilities instead of equipment, but that should reverse in 2020.

Limited Read-Throughs

Without more detail, it’s hard to make read-throughs to other companies. Maxim (MXIM) did report better-than-expected growth in 100G laser drivers for data centers, but Xilinx (XLNX) didn’t seem to get much uplift from its DC business. At a minimum, I would think that Mellanox’s healthy Ethernet switch results bode well for sales of Broadcom’s (AVGO) most advanced switching products, but Mellanox may also be gaining share at Broadcom’s expense.

Outlook

With the Chinese government’s decision still in the air, Mellanox continues to trade below the $125 deal price. China’s government may well be concerned about the significant influence that Nvidia-Mellanox could have on China’s growing AI sector, but I’m not sure that the deal really changes the landscape all that much. I do think there’s a “better together” argument with Nvidia and Mellanox, but Nvidia and Mellanox will still be formidable competitors in their areas of expertise, whether they’re together under one umbrella or not. In other words, I’m not sure that denying the deal really reduces any risk or vulnerability within the Chinese AI marketplace.

I also continue to see relatively little long-term risk to Mellanox if the deal should collapse. Mellanox battered Intel (INTC) in the InfiniBand business, and the company is performing quite well in high-end Ethernet, with significant long-term leverage to data center spending growth (particularly hyperscale). Though I’m not suggesting Mellanox would, will, or should break its deal with Nvidia, I think there is a valid standalone argument underpinned by mid- to high-single digit long-term revenue growth and mid-20%’s adjusted FCF margins (as well as strong operating margins).

Bottom Line

The longer the proposed Nvidia deal stays open, the clearer it becomes that Nvidia is getting a good deal. I do still expect the deal to close, but I likewise see low long-term risk to Mellanox shareholders if the deal collapses, making the spread between today’s price and the deal price worth going for as a short-term trade.

Disclosure: I am/we are long AVGO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.