Mellanox Technologies: How Low Can It Go?

"We see Intel as the primary competition, and we're very concerned. For us, the game plan is to stay ahead of Intel. Today, we are leading by a generation." - Yakov Shulman, CFO, Mellanox Technologies

The semiconductor industry is rife with boom and bust cycles. There are anomalies like Intel (INTC) in the mid 80's to late 90's, or Qualcomm (QCOM) in the iPhone (AAPL) era, but for the most part, it's feast or famine. Exhibit A is a two year chart for Mellanox Technologies (MLNX), a fabless semiconductor company that designs, manufactures and sells high-performance interconnect products that help to facilitate data transmission between servers, storage and systems.

(Chart Source: Yahoo Finance)

There's an old Wall Street chestnut that says an investor shouldn't catch a falling knife, but after a drop from $120 to $34.50, I purchased some shares a shade under $35. If we rewind to 2102, the company earned $3.57/share when it shot up to $120. For 2013, that figure declined to an estimated consensus of $1.17, which accounts for the sell off. However, if we fast forward to 2014, average earnings/share estimate is for $2.22. At $35, that gives us a forward P/E of 16. I find that metric reasonable, and will continue to dollar cost average, even if the price keeps falling.

This really isn't just an article about Mellanox Technologies, but the brewing battle between Mellanox and Intel for supremacy in the data center. I'm betting on Mellanox. To buttress my investment thesis, the entirety of this article is helped by the most recent Mellanox Technologies 10-K, its last conference call, and the presentation at the Barclays Global Technology, Media and Telecommunications Conference.

A Brief Company Background

It's all about Big Data. Mellanox Technologies allows seamless integration between servers and the end users with their insatiable appetites for all sorts of information. It's the only game in town for 56 gigabit per second InfiniBand products. InfiniBand is an industry-standard architecture that provides specifications for high-performance interconnects. According to the annual report, these high-performance interconnect solutions remove bottlenecks in communications between compute and storage resources through fast transfer of data, latency reduction, and improved central processing utilization.

Although the majority of the company's revenues come from InfiniBand (which they've been shipping since 2001), it's also an early supplier of 40 Gigabit Ethernet to the market. This provides Mellanox with the opportunity to gain additional share in the Ethernet arena as users upgrade from one or 10 Gigabit to 40 Gigabit. Both technologies are crucial in the Cloud, and Mellanox is a one stop shopping place for the digerati looking to make their data centers run at mind boggling speeds.

As far as customers go, Oracle (ORCL) (which owns 10% of the company) put Mellanox on the map by exclusively using the organization's InfiniBand offerings. Other heavy hitters followed suit. The enclosed diagram gives you a detailed presentation of Mellanox clientele:

(Diagram Provided By Mellanox Technologies)

In regards to marketing, the company primarily sells to large server OEMs such as IBM (IBM) and Hewlett-Packard (HPQ). Both entities represented 35% of revenues in Q1, 2013. In aggregate, OEMs constitute approximately 90% if its sales, with the remaining 10% coming from distribution. Enough said.

The Ensuing Battle With Intel

Where semiconductors for wireless handsets are concerned, it's common knowledge in investing circles that Intel is behind the eight ball. They're also a generation behind in InfiniBand and Ethernet solutions for Big Data transfers. Nevertheless, they're a formidable opponent with deep pockets for R&D and acquisitions. Intel recently circled the wagons by purchasing four companies to compete head to head with Mellanox. CFO Yakov Shulman at the Barclays Global Technology, Media and Telecommunications Conference:

• "Our closest competition is Intel. Intel acquired 4 companies to compete with us. Intel acquired NetEffect for Ethernet, they acquired Fulcrum for Ethernet switching, they acquired QLogic InfiniBand assets, as well as Cray Interconnect."
• "To date, Intel offers 40 gig solution on InfiniBand side. We hear that they decided to skip 56 gigabit per second generation and will try to intercept us at 100 gig."
• "We expect to introduce our full end-to-end 100 gigabit solution sometime in 2014, 2015 time frame. We think that Intel is behind us. We estimate that they will launch their solution in 2015 time frame."
• "For us, it's a matter of execution. I think we have better technology, and if we execute well, we could take significant market share."

The Mellanox Counterpunch

As part of its plan to deliver the next generation of interconnect, with speeds of 100Gb/s in 2014, 2015 timeframe, Mellanox acquired Kotura and IPtronics. These acquisitions bring to Mellanox important technology capabilities for interconnect solutions at 100Gb/s and beyond. By owning the core competency and controlling all the building blocks of the interconnect solution, Mellanox is positioned to continue to lead the fast interconnect market and to serve the High Performance Computing, Web 2.0, cloud, storage, database and financial applications.

Here's the Cliff Notes sales pitch as paraphrased by CEO Eyal Waldman in the latest conference call:

But even when Intel comes with a 100 gig solution, Mellanox has so many sticky design wins, it will take some time for Intel to really become a viable competitor in those markets. If you look at multiple design wins Mellanox has with Oracle, Teradata (TDC), IBM, and EMC, when Intel comes with their solution, these customers will have to rewrite some of the code they created around Mellanox products, and Mellanox would have to qualify the code.

Valuations

Comparing Mellanox Technologies to Intel is no apples to apples comparison. Besides the technology, the only thing the two companies have in common is that they both greatly underperformed a roaring stock market in 2013. Year to date, Intel has moved from $21 to $23.70. If you screened for a Dog Of The Dow, you'd probably unearth Intel. Mellanox is a pure play on the semiconductor market for Data Centers. Intel is a behemoth, with tentacles that reach into many markets.

If you're an investor looking for fixed income, Intel may be a good bet for you. The dividend yield is 3.8%, but the P/E Ratio is 13, with projected earnings growing at a paltry 7.5% for the next 3 years. I've been through three market crashes: 1987, 2000 and the "Great Recession" of 2008-2009. Because of the instability at times in the market, I prefer my fixed income in CDs. However, your comfort zone may be different. That said, I think Intel's days as a growth company are over.

With Mellanox, earnings are projected to grow 100% in 2014. Wall Street is a forward looking mechanism, and October is when the smart money starts crunching numbers for the next calendar year. Although there are headwinds in the market like a possible government shutdown, I'm wagering that Mellanox technologies has stopped falling. The short float is 13.5%, and with the next conference call scheduled for mid October, I'm betting on a short squeeze. This is a good investment for the next year.

Medidata Solutions: Priced For Perfection

"Medidata is uniquely positioned at the intersection of life sciences and technology." - Tarek Sherif, CEO Medidata Solutions

The best of both worlds. That's the enviable position Medidata Solutions (MDSO) finds itself in as we enter the Fall of a blistering year in the stock market. Two sectors that have outperformed are Cloud Computing and Biotech. Medidata's flagship product Medidata Rave sits solidly in the center of these two arenas. It offers cloud based solutions in the clinical trial process for biotechnology companies, medical device manufacturers, and big pharma.

The company had its IPO in June 2009 at $14/share. It barely budged from its initial share offering for two years as investors slowly waded back into the stock market. Once earnings and revenues increased at a healthy pace, investors took notice, and elevated the share price from $16 to $100 in 24 months.

(Chart Source: Yahoo Finance)

At par value, the equity sports a trailing twelve month P/E Ratio of 121. Although earnings growth for 2013 is a healthy 33%, the consensus estimate on Wall Street drops to 17.5% for 2014 (which may be conservative). My contention is that Medidata Solutions is ahead of itself, and may be due for a significant haircut if the next quarter doesn't live up to lofty expectations, or guidance disappoints. After all, Wall Street is looking for next year's numbers now.

To make my point, the remainder of this article will be liberally paraphrasing and quoting from the company's annual report, most recent conference call, and its presentation at the Morgan Stanley Technology, Media & Telecom Conference.

The Company Near Term

The Pharmaceutical Industry spends spends $90 billion a year developing new drugs, and Medidata Solutions is the largest task provider of solutions to the life sciences companies. According to the CEO, in its core market, it has over 50% market share, and has achieved "critical mass" in terms of the kind of data it's collecting. The company's chief competitors are Oracle (ORCL), Perceptive Informatics, and Tableau Software (DATA).

The annual report states primary product Medidata Rave is built on industry standards, enabling interoperability with legacy and third-party applications throughout the development process. CEO Sherif gives his spin:

We focus on replacing paper-based, Excel-based, and legacy-based processes in drug development in actual clinical trials with a very innovative disruptive technology solution that helps them to both save money, and to drive down times in drug development.

The company's software has end-to-end support for Unicode characters, required to deliver multi-lingual studies, which enabled its globally positioned sales force to land a who's who of pharmaceutical juggernauts. Johnson & Johnson (JNJ), Roche and AstraZeneca (AZN) are clients of note. Medidata can also boast a laundry list of biotechnology all-stars on its roster. The company's five largest customers accounted for 29%, 31% and 43% of Medidata revenues in 2012, 2011 and 2010, respectively. However, in 2012 and 2011, no single customer accounted for 10% or more of total sales.

Medidata is taking market share from some of the incumbents, or the legacy solutions. Last year, it added 100 new customers. It has 363 customers currently. There are over 2,000 companies globally that develop drugs. So there's a wide open field for it to continue to add new names.

It has a subscription model in terms of customers having the right to use Medidata technology for a period of time. It drives volume in terms of the adoption of the technology solutions, it recognizes revenue on a ratable basis over the contracts short-time, and its strategy is to drive adoption of the company's technology through its infrastructure, which is highly scalable on a gross margin basis.

The applications are very sticky. Last year, its retention was in the high-90% range, and that's not even counting the up sell opportunity it has with those customers. Last quarter, the retention rate rose to 99%.

Although this gestalt of information is impressive, it still doesn't warrant a trailing P/E Ratio of 120. However, as experienced investors understand, you are paying for future earnings growth. Medidata Solutions executives believe they are at the right place at the right time to take advantage of the paradigm shift in drug discovery.

The Company Long Term

Although trends in pharmacology such as Personalized Medicine, which includes genomics and targeted therapeutics, will likely be catalysts going forward, it is the expansion of Medidata's core competency that will drive share price higher. Recently, the company broadened its platform dramatically, and now focuses across the entire drug development spectrum. So from conception of a clinical trial through to completion of that trial. Last quarter, non-Rave revenues increased 144% year-over-year.

CEO Sherif:

We are able to increase market share across multiple functions within a single customer. As we identify new customer needs, our cloud model makes it much faster and more efficient to develop and deploy new functionality and solutions, continuously broadening and improving our platform and therefore, expanding our revenue opportunities.

Medidata is helping to define the vertical cloud business model, and its power is evident in its financial results. Not only did it exceed its previously stated outlook for revenue and EBITDA, and saw cash flow from operations increase to record levels, but it also continued to lead its SaaS peers in profitability measures. Second quarter highlights included:

• Application services grew 36% year-over-year.
• 45% of existing clients purchased more than one product, up from 41% in the first quarter.
• Total revenues for the second quarter of 2013 were $68.1 million, an increase of $14.6 million, or 27%, compared with $53.5 million in 2012.
• Application services backlog for the remainder of the year as of June 30, 2013, increased to $110 million, up 38% over the comparable period a year ago.
• Total cash, cash equivalents and marketable securities were $140.4 million at the end of the second quarter, an increase of $26.5 million, or 23%, as compared with $113.9 million at the end of the second quarter 2012.
• Cash flow from operations was a record $26.2 million in the second quarter, up 361% year-over-year.

No question is was an outstanding quarter, and I realize sell side Wall Street analysts are giving Medidata premium pricing, but I still remain convinced the stock is overvalued.

Conclusion

Medidata Solution's short float is only 5.5%, so the smart money is betting the stock has room to run. It keeps ascending to new highs on a daily basis, so short sellers beware. That said, its price/sales is 11, price/book is 16 and cash/share is only $1.45. That seems expensive to me. Young growth companies plow a lot of their revenues back into SG&A [Selling, General and Administrative Expenses] and R&D, and therefore, don't make a dime. That's not the case with Medidata. It's an extremely profitable and well run company, even with an R&D budget that's 19% of revenues.

Many investors subscribe to the Efficient Market Hypothesis where prices reflect all publicly available information, and that prices instantly change to reflect new public information. I take a different approach and believe that investors aren't always rational. Although the rank and file at Medidata are doing a great job where the company is concerned, in my opinion, the stock isn't worth $100, not at this juncture. I wouldn't short it. Personally, I don't short individual stocks, and that's especially true in a bull market.

Bottom line is I'd like to own this equity, but not at the lofty valuation. My purchase price for Medidata Solutions is somewhere between $65-$75. Its 200 day moving average is $64, and I prefer to buy my holdings for bargain basement prices. Your investment style may be different, and this stock has a full head of steam. If you don't mind the macro issues that hover over the stock market, this a great choice for short-term momentum players.

Stay Hungry

In most aspects of your life, it's best not to spread yourself too thin, but in investing, it's just the opposite. Diversification is the recommended plan of attack, and for the majority of retail investors, I would agree with that assessment. The original spider (SPY) (an ETF that tracks the S&P 500), is a terrific way to take advantage of a market that's running. It's the benchmark that professional portfolio managers judge themselves by. If you beat the S&P 500, you're outperforming the overall market, which at times is difficult to do as a stock picker.

For the past year and a half, I've been putting my investable assets in the technology sector. Most specifically, I bet on small cap companies that are levered to the smartphone and tablet markets. Hit a major cold streak for awhile. Both Velti (VELT) and Glu Mobile (GLUU) were big disappointments, but after a 30% gain in the portfolio the past six weeks, I'm gaining ground. A 110% rise in Facebook (FB) and a 75% profit in Synchronoss Technologies (SNCR) purged a lot of sins.

It's a given we're in another bull market, but nobody really knows how long the duration will be, and when the next significant correction will come. One theory I've heard, and one that I subscribe to, is that technology may be the place to be for the next three years. The technological change from legacy software systems to cloud based applications for the enterprise is one big area of growth. In addition, the explosion of wireless broadband for the corporation as well as the consumer is another. As automation engulfs us, companies are making the transition, and I want to take advantage of this evolution.

Nevertheless, technology companies can leapfrog each other in a heartbeat, and the losing companies can find significant erosion in market share, as well as share price in a nanosecond. A buy and hold strategy (a strategy I prefer), often doesn't work with small to medium sized organizations in the transformational era that we live. However, these smaller companies is where the growth is, so I've got some of the securities I own on a short leash.

I've recently sold some stocks because of very nice gains. We may be heading into a corrective phase with the government taper looming, plus, September is a historically bad month, and October is known for its market crashes. I want to have plenty of cash available to take advantage of a dip. If the market keeps running, there is always the upcoming earnings season, and promising companies may be on sale after an earnings miss. The remainder of this post will discuss some of the moves I've made the last two months, and the reasons for doing so.

Glu Mobile

A few months ago I liquidated my position in mobile gaming company Glu Mobile for $2.10/share. Although I sold half of my shares for a 40% gain when it traded at $5.90 in the Summer of 2012, I was underwater with my investment. This is because I loaded up on the company again when it dropped to $3. Besides the dip in price, one reason I jettisoned my stake is a lack of execution. Management has also recently changed their accounting practices, and the company has diluted shares by putting more on the open market. Although it rallied for awhile on a Microsoft (MSFT) buyout rumor, it can't seem to get off the mat.

This company has a lot of potential, and if they can monetize the multi-player gaming platform, it may get some price appreciation in the 4th quarter which is historically strong for Glu. They're also involved with mobile gambling in the United Kingdom which is another revenue generator. With my average price of $3.25, I thought Glu mobile could be a five or ten bagger if they started to execute. However, they seem to have dropped the ball this year after a nice 2012.

What this company needs is for a larger organization to throw investors a Hail Mary pass in the form of an acquisition. Although this is a distinct possibility, and they may have a good 4th quarter because of the Christmas selling season, I wasn't willing to wait. The dilution of shares, and change in accounting procedures were red flags. I wanted to give them till March to get their act together, but with the market running, decided to invest elsewhere.

Teradata

Data warehousing and analytics company Teradata was a short lived investment for the portfolio. I only owned the stock for six weeks, but made a 30% profit on a company that is growing at 13% a year. Double digit growth is very impressive, but the stock almost reached its consensus price target for the next 12 months in a month and a half. I bought at $48, it ran to $65, and I sold on the way back down at $62.

It was a toss-up whether to keep it or sell it because I bought Teradata at multi-year lows, and believe it has a bright future. This is especially true with new initiatives like Hadoop which may raise revenue growth. However, the Las Vegas over-under lines told me that the stock could go lower after a 30% gain, and a 15% growth rate. It dropped to $56 shortly after I sold it. With a forward P/E ratio of 21, it seems a bit expensive to me. I've got it on my watch list now.

Fusion-io

I held data accelerator Fusion-io (FIO) shorter than my position in Teradata - three weeks, or better put, 15 trading days. Again, I had a 30% gain in the equity. The stock got hyped up after a blistering IPO, and one blowout quarter when two of their hyper-scale clients, Facebook (FB) and Apple (AAPL), were buying Fusion-io products hand over fist. Clearly at $11, the stock was oversold, and that's when I purchased it. I like to bottom fish, especially with former high fliers when investor psychology goes in the opposite direction.

The stock is heavily shorted, and jumped 40% in two days after Pac Crest stated that $22-27 would be a good buyout price for the company. I wanted to keep Fusion-io, but needed to raise some cash for the possibility of an overall market correction. Thirty percent gain in three weeks is a tidy profit. Best-case scenario, the stock drops back below my purchase price of $11, and I will buy more shares. Worst-case scenario, the rumors drive the story line forward, and they get scooped up by a whale like IBM (IBM).

Facebook

Facebook is in my investing highlight reel - over 100% gain in a little over a year. There's always a bit of luck involved when you buy a stock near its 52 week low, but that's what happened when I bought the company at $19. Fifty percent off of the IPO price. In my last post, I said I thought it may double to $100 in twelve months, if not by Christmas, if they pull off another monster quarter, and the markets keep humming. I still believe that, and continue to consider the company a cornerstone in the portfolio.

On a personal note, I'm not a Facebook user. I utilize Twitter. Twitter is a great way to aggregate news all over the Internet. Twitter's recent announcement that they're going public has put some pressure on Facebook the last few days, but this will soon subside. The two technologies really compliment each other, although they compete for advertising dollars. Facebook is in the Investor's Business Daily top 50 stock picks. This is like performance enhancing drugs for an equity because it's where all the hot money flows. You've come a long way, baby.

Synchronoss Technologies

Another pillar in the portfolio, Synchronoss Technologies has been a workhorse for me, just like it is for telecommunications companies globally. Although 75% of sales are from smartphone activation, this will soon change because they are quickly becoming the cloud storage option for customers of clients like AT&T (T) and Verizon (VZ). This stock has all the essential ingredients to become like a Cisco (CSCO) or EMC (EMC) in their growth heyday back in the 1990's. Not that Synchronoss competes with Cisco or EMC, just in the price appreciation potential.

Wells Fargo believes the company can beat Wall Street's expectations, and grow 23% for the next three years. I agree with them. The stock is a bit pricey now, but it's had a terrific run. One thing to consider with Synchronoss is that they are not one of these sexy technology stocks. They do all of the heavy lifting for the telecommunications carriers. Back in the 90's I invested in Internet infrastructure plays, not the dot coms, and did quite well. I continue the same tack as Web 2.0 builds out.

Nuance Communications

Although I bought Nuance for their superior voice recognition technology, I'm waiting to see what Carl Icahn does with his 17% stake in the company. Icahn also has a stake in Apple, so speculation is that he will push for an acquisition. I really thought all the headline grabbing news concerning Icahn and Nuance would push shares higher, but that hasn't been the case. I expect a 15% return from Nuance per year from my purchase price of roughly $19, a multiyear low for the company.

Allot Communications

Israeli based Allot Communications (ALLT) is slightly above my purchase price of $12. This is a short term holding unless they can provide guidance. The company is currently under pressure from a numbers miss last quarter, and many Israeli based stocks are feeling the pain of a civil war in Syria. I'm giving Allot two quarters to produce better numbers. Company executives believe that telecommunications spending in Europe and China is picking up, which could boost revenues. This is another wireless broadband infrastructure play.

Ruckus Wireless

Ruckus Wireless (RKUS) is a recent IPO. At $16.50, it trades about $3 above the public offering price, and about $3 above my average cost per share. The company provides the infrastructure for WiFi hotspots, both in the enterprise and with telecommunications carriers. Nokia-Seimens is a large partner, and the equity has rallied on rumors of an acquisition by the larger company. Cisco is a big competitor, but many telecommunications carriers prefer duo vendors. I like their prospects even without being bought out.

Conclusion

The concentrated portfolio only holds five stocks right now, plus the cash I've raised from selling Fusion-io. This is a dangerous strategy, especially if technology securities go into a funk. Nevertheless, my perspective is that we're in a three-five year window of opportunity for investors with the buildup of wireless broadband and cloud infrastructure. I'm willing to take my chances.

However, after living through the crashes of 1987, 2000, and the most recent "Great Recession", I'm still skeptical of Wall Street. I do my own research because I remain confounded by the sell side research houses, and their vested interests with the companies they cover. I'm not suggesting all sell side research is bad, in fact it's just the opposite. If you need a blueprint for a particularly difficult company to understand, the professionals do it very well. I just take it with a grain of salt because you just don't know who they're in bed with.