In mid-February, we shared our research report on AMERCO (UHAL), the deeply undervalued and underfollowed holding company that owns U-Haul, the nation’s dominant moving equipment rental company. At the time of our report, we outlined why investors could have acquired AMERCO for only 11x EPS despite the fact that its U-Haul truck rental business has a dominant and unassailable competitive lead in its niche industry, is earning record profits, and is taking market share as a result of its lower cost base, larger fleet and expanding network. In addition, we also highlighted how investors may have overlooked the fact that AMERCO generates nearly 30% of its free cash flow from its very valuable and steady self-storage real estate portfolio.
We wanted to provide investors with an update following the dissemination of our original report. Recent financial results and industry commentary continue to validate our thesis: U-Haul’s expanding fleet size and vastly larger network is expanding its competitive advantage in the self-moving truck rental market, forcing competitors such as Budget Truck Rental (a division of Avis Budget Group: CAR) to retrench from the market.
Recent Industry Commentary Continues to Validate Our Thesis
We think investors should not overlook the fact that AMERCO has been run by the Shoen family, which founded the company, for nearly 70 years, and that the family retains a 55% equity interest in the business. Current CEO Joe Shoen, son of founder Leonard Shoen, has run UHAL since 1986 and has continuously enhanced U-Haul’s competitive advantage and market share at the expense of its competitors.
U-Haul’s primary competitors, Budget Truck Rental and Penske Truck Rental (a division of Penske Truck Leasing), are both divisions of far larger companies and not core profit drivers for their respective management teams. It is telling that on the Q4 conference call for Avis Budget Group, management indicated further retrenchment:
“I think there are significant opportunities in Truck, but they're longer term in nature. As we talked about last quarter and as I mentioned today, we are in the process of repositioning that business to be a somewhat smaller, and hopefully, more profitable business over time. That process is going to take at least the first 6 or 9 months of 2013 and possibly close to the entire year... and clearly, at this point, it does only represent around 6% of our revenue.” [emphasis added]
It is interesting to note how management waves off the issues with the truck business by stating that it's “only” 6% of their revenue.
We believe Budget’s attempts to downsize will facilitate further market share gains for U-Haul. Budget’s retrenchment has given U-Haul an opportunity to add even more trucks and locations to its already larger fleet and network. We believe Budget’s retrenchment demonstrates that competitors are finding it increasingly difficult to profitably compete with U-Haul.
AMERCO Continues to Report Record Financial Results
After we issued our report on AMERCO in mid-February, the Company issued its Q3 results for the period ending December 31, 2012 (AMERCO’s fiscal year ends on March 31, 2013). Management has continued to execute in all lines of its business. EPS growth was an impressive 15% for the quarter on the back of 5% revenue growth in the U-Haul segment and 15% revenue growth in the self-storage segment. EBIT margins continue to be strong as U-Haul captures market share and competitors retrench.
The core U-Haul rental business achieved a 5% increase in revenue and leveraged its fixed cost base to generate an 11% increase in income contribution from the U-Haul division.
From a competitive perspective, U-Haul can utilize its increased profits to invest even further in fleet size and to increase its network, or it can choose to invest in lower prices to put even further pressure on Budget and Penske. Either way, its competitive advantage is continuing to widen. U-Haul’s financial results contrast significantly with the most recent results reported by Budget, which outlined that its truck rental business was facing a significant decline in profitability and that it was shrinking its fleet size:
"Revenue in our Truck Rental segment was up 1%, as a 4% increase in pricing and higher ancillary revenues more than offset a 3% decline in volume. Adjusted EBITDA declined $6 million, primarily due to higher maintenance, insurance and fleet costs. As we previously discussed, the results in our Truck Rental segment reflect costs we are incurring to reposition this business, which over time will include a reduction in our fleet size. This strategic repositioning will impact reported results for this segment for much of 2013 as well."
The self-storage business continues to generate stable, predictable profits. AMERCO was able to invest in another 0.6 million square feet of storage space while maintaining its high occupancy levels (80%).
The insurance business is a relatively small business unit. After deciding to run off non-core insurance lines, management will focus Repwest on its small but profitable niche of insuring U-Haul truck rentals. Meanwhile, the Oxford life insurance business continues to perform well.
Valuation Remains Attractive for Such a Dominant Business
We continue to believe fair value for AMERCO shares to be higher than $200. Below are current capitalization and valuation metrics for UHAL.
We compare AMERCO to a selected number of publicly traded companies that operate a similar rental model, or benefit from “network effects” where incremental hubs / customers benefit the market leader.
Compared to these comparable companies, AMERCO is significantly undervalued when considering that it generates a higher EBIT margin than most of these companies, is arguably in a more dominant competitive position, and has a large real estate business. As it pertains to U-Haul, we think Waste Management (WM), Republic Services (RSG) and Sysco (SYY) are valuable comparisons in that they are high fixed-cost businesses that operate in commoditized industries, operate across the US, and are expected to grow roughly in line with inflation. These businesses reasonably trade at ~8x EBITDA, 12x-14x EBIT and 17x-19x EPS.
In our opinion, AMERCO’s U-Haul business line has far superior economics to publicly traded car rental businesses such as Hertz Global (HTZ) and Avis Budget Group. The car rental industry is relatively competitive whereas in its market niche, U-Haul is the clear market leader and has an expanding competitive advantage.
Furthermore, unlike its car rental peers, AMERCO generates 30% of its cash flow from its valuable self-storage real estate portfolio. We believe that investors in self-storage REITs such as Public Storage (PSA), Extra Space Storage (EXR), CubeSmart (CUBE) and Sovran Self Storage (SSS) can achieve far superior risk-adjusted returns by purchasing shares in AMERCO relative to their REIT investments.
For a self-storage REIT investor, buying shares in AMERCO is akin to acquiring the third largest self-storage real estate portfolio in the US, while getting the nation’s dominant truck rental business at a large discount. If a REIT investor were to value AMERCO’s real estate at only 22x EBIT (a significant discount despite AMERCO’s taxes), this would value U-Haul's truck rental operations at less than 2x EBIT.
It should be noted that although AMERCO does not pay a regular dividend yet, it does pay special dividends. Last year, its special dividend was $5.00 per share, nearly a 5% yield on the stock's 2012 average trading price of $102. We think that management's track record of shareholder-friendly capital allocation policies will result in cash either being returned to investors or intelligently reinvested in AMERCO's promising business lines.
At current valuations, AMERCO shares trade at only 14x analysts' estimate of 2013 EPS. AMERCO will be releasing its year-end results this week, and we expect the company will announce yet another record year for earnings. Furthermore, AMERCO could announce additional special dividends in 2013 given that the business continues to generate substantial free cash flow.
Disclosure: We are short shares of NOW. Please click here to read full disclosures.
Yesterday, ServiceNow's (NOW) largest shareholder, Sequoia, filed a Form 4 disclosing its first major divestiture of NOW shares. The May 1st filing discloses a 6m share distribution that Sequoia quietly made to its limited partners on Monday (April 29th). This reduced Sequoia’s stake to 18.3m shares and transferred ownership of the 6m shares to an assortment of pension funds, endowments, and fund-of-funds that make up Sequoia’s limited partner base. While a direct share distribution partially absolves Sequoia from market timing decisions, it can place heavy selling pressure on a stock. This is because limited partners are typically not equipped to analyze individual public securities, preferring to instead sell shares immediately upon receipt. Since Monday’s 6m share distribution, NOW’s share prices has fallen by 7.8% on an average of daily volume of 2.4m. It can then be argued that this abnormal volume and price activity is the direct result of Sequoia’s distribution. As Monday’s distribution only represented 25% of Sequoia’s total ownership stake, additional forced selling may lie ahead.
Sequoia, along with JMI Equity and Greylock, was one of ServiceNow’s original venture capital investors. Sequoia first built its stake in November 2009, investing $51.6m for a 23.9m share stake. This equates to a cost base of just $2.15/share relative to NOW’s current price of $38.80. But as Fortune recently put it, “for many VC firms, getting into a hot company is easier than getting out.” Following NOW’s June 2012 IPO, Sequoia had their shares locked-up until the beginning of February. Rather than immediately distributing their shares after the lock-up expiration, Sequoia chose the hold shares through NOW’s April 25th Q1 2013 earnings release. They were rewarded as NOW shares traded to an all-time high of $43.39. While Q1 Billings were above consensus and revenue slightly beat estimates, forward-looking comments from management suggest that NOW’s growth may have topped out. On the Q1 earnings call, CFO Michael Scarpelli commented, “We're still expecting a strong quarter in Q2. But we kind of expect going forward…Q2 to Q3 are pretty much going to be flat quarters from a bookings perspective.” The sell-side overlooked this comment, as well the weak Q3 and Q4 revenue numbers implied by full-year guidance, and issued their typical round of congratulatory research notes. Sequoia, on the other hand, decided it wanted to partly cash out.
After Wednesday’s Form 4 filing, Sequoia continues to hold 18.3m shares. As Sequoia’s limited partners are sitting on roughly 2000% paper gains, they will be eager to crystalize these profits. If a 6m distribution causes a two-day 8% correction, then further distributions may result in a similar outcome. And once the makeup of NOW’s shareholder registry completes its rotation from locked-up VCs to momentum investors and retail traders, future growth stumbles are less likely to be tolerated. This week’s Sequoia distribution, combined with the foreboding statements on the quarterly call, may finally induce a correction of NOW’s dotcom-era 16x 2013E Revenue multiple. We’ll be following the Form 4 filings closely.
Disclosure: We are short shares of EZCH. Please click here to read full disclosures.
Over the past few weeks, we’ve shared our EZCH investment opinion in a pair of articles, outlining our belief that EZCH’s $717m market capitalization, 8.0x 2013E revenue multiple, and 32.7x 2013E GAAP P/E (adjusted to include $0.39/share of stock-based compensation) are wholly unjustified. The Bull case depends on EZCH growing well in excess of the overall router market thorough 2016, a challenge we believe is unrealistic given an avalanche of near- and long-term business risks. Customer concentration is dangerously high, newly introduced competition from Broadcom could pressure design wins, Huawei’s recent order delay proves that in-house design risk is ever present, and weak end-market demand will pressure EZCH’s self-imposed 30% revenue growth hurdle (slide 8). To justify EZCH’s almost 2x valuation premium to the S&P 500, it must overcome this hurdle each and every year through 2016. Most EZCH investors discount these risks, instead trusting a management team that has over-promised and under-delivered for years, growing the revenue by just 11% annualized between 2009 and 2012. But since some took the time to reply to our article, we feel a response is due.
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Sources: EZCH 2012 20-F, Q4 2012 6-K, Capital IQ
A Response to Feltl & Co’s ‘Short-Seller’ Report
Following our March 11th report on EZchip, Feltl & Co. issued a one-page response that addressed some of the arguments in our initial report. Feltl also reiterated their “Strong Buy” recommendation that’s been in place since they initiated coverage on August 22nd, 2012 at a price of $32.28. Feltl’s research note gave EZCH investors the positive reinforcement they craved. After reading through the March 11th report, we believe that Feltl’s response consisted of four key points:
- Broadcom’s June 2012 Linley commentary proves that BCM 88030 targets the switch market, not EZCH’s core end-market of edge routers;
- Even though Broadcom introduced the BCM 88030 almost a year ago, no explicit customer wins have been announced;
- Feltl believes ZTE and Cisco are locked in for NP-5 and;
- A long sales cycle suggests no immediate competitive threat
In the interest of continuing the conversation, we’ve taken the time to address Feltl’s response below on a point-by-point basis.
1) More Recent Broadcom Comments Unequivocally State BRCM’s Intention to Compete in EZCH’s Core Market of Edge Routers. While Feltl cites Broadcom commentary from a June Linley conference, we’ve placed more credence on December 2012 remarks. At their yearly Analyst Day, Broadcom explained that edge routers are their chief addressable NPU end-market, "Another example of a product that expands our SAM is [a] 100 gig network processor [BCM 88030] that we introduced earlier this year…this is a product that [is] very well-positioned for further penetration into the traditional network processor market in EDGE routers primarily [emphasis added], as well as in some core router applications, as well as packet transport applications." To drive this point home, Broadcom included a full-page graphic in the accompanying Investor Presentation that illustrates this remark. Whether EZCH likes it or not, it will be competing with BRCM for new Edge Router NPU business.
Source: Slide 35, BRCM December 6th, 2012 Analyst Day Presentation.
2) Because Sampling and Testing Occur Over a Protracted Period, the Delay Between Broadcom’s BCM 88030 Announcement and Customer Wins Should be Expected. Feltl correctly states that the BCM 88030 was first announced in April 2012. But this passage of time does not imply that the competitive threat is removed. As EZCH investors know through experience, the sampling and design process is iterated with the router vendors over a multi-year period before public customer wins are announced. EZCH first disclosed the research-stage details of its comparable NP-5 product in May 2011 and even after nearly two years, it has yet to provide samples to customers:
<Q - Paul Williams>: The NP-5, when do you think you’ll be able to provide samples to your customers on that?
<A - Eli Frutcher (CEO)>: In [the] June to July [2013] timeframe, I would say. (EZCH Q4 2012 call).
And in the case of EZCH, timelines can slip. As of November of last year, EZCH expected to sample an NP-5 “in the first quarter of 2013,” a deadline that had previously moved from Q4 2012 (Q1 2012 EZCH call). Now, the expectation is for late Q2 or early Q3 2013. As for Broadcom’s timeline, it expects to have customers in 2013, “And by the way, you should be seeing all these products [BCM 88030] in production, right, with customers [in] 2013.” (BRCM 2012 Analyst Day).
3) Comments from EZCH’s Management Team Indicate that neither Cisco nor ZTE is a Confirmed NP-5 Customer. Rather, EZCH is partial to unconfirmed language like, "We expect…these [Cisco] platforms migrate to NP-5" (Q4 2012 Call) and “We…believe that we will be able to expand to additional platforms [at Cisco]” (Q3 2012 Call). This guarded language is necessary since the vendors may be comparatively sampling and testing NPUs from multiple sources, including their own in-house designs.
In concluding that ZTE will transition to NP-5, Feltl references the following quote from EZCH’s Q2 2012 press release: “ZTE became our second largest customer…and has started NP-5 designs.”
When this issue was examined on the ensuing conference call, EZCH again retreated to more speculative rhetoric: “So I really cannot name customers that are designing NP-4, NP-5 now, but I can tell you in general that customers that are already in production with NP-4 design already with NP-5” (Q2 2012 Call). While EZCH rightly deserves credit for its strong relationships with Cisco and ZTE thus far, the recent uncertainty around Huawei reminds us that these deals aren’t final until wins are definitively announced. More recently, investors pinned their hopes on EZCH’s presentation at the 25th Annual Roth Capital Conference. With a 7:30pm presentation time, EZCH wasn’t exactly awarded a prominent timeslot, nor did it decide to webcast the presentation like many of the other 300+ companies who presented. This omission of a recorded webcast or transcript can ensure investors that no new material information was presented per Regulation Fair Disclosure. Nonetheless, some are reading into management’s comments to conclude that NP-5 wins are a certainty, an assumption we continue to view as extremely dangerous in light of management’s history of over-promising and under-delivering.
4) While a Lagging Product Cycle Does Provide EZCH with Run-off Value, EZCH’s $700m Market Capitalization Necessitates Substantial Future Growth. EZchip is not a cheap stock. An 8x 2013E Revenue and 32.7x 2013E GAAP P/E multiple are indicative of a rapidly growing business. To achieve the 30%+ annual revenue growth targeted in the Q4 2012 Investor Presentation, EZCH must hit each of its growth levers in unison -- double-digit end-market growth, market share expansion, and 40% 4-year ASP growth. As a business whose revenue fell from $63.5m to $54.7m over the past year, EZCH has yet to deliver on this promise.
Even if EZCH is successful in retaining its current customers, it would be hazardous to assume vendors wouldn’t take advantage of BRCM’s entry to pressure EZCH on pricing and other terms. We are not alone in voicing these risks; EZchip readily acknowledges the competitive shift in the marketplace:
“We believe that competition in this market will become more intense in the future and may cause price reductions, reduce gross margins and may result in loss of market share, any one of which could significantly reduce our future revenue and decrease our net income." -EZCH 2012 20F
For EZCH to sustain its almost 2x valuation premium to the S&P 500, it must not only transition each NP-4 customer to the NP-5, it must also increase unit pricing and networking market share, both of which are questioned in the statement above. This task could be made all the more challenging by continued softness in the router and switching markets. Last week FBR securities released a report stating that the market for routers and switches has hit a “dead end.” The analyst went on to state, “Looking ahead, we see the potential for additional negative technological trends that could significantly blur the lines between routers, switches and servers.” As networks move toward the cloud and data centers, demand for traditional wireline infrastructure will continue to soften. This sentiment is confirmed by Gartner, a technology research house, who predicts industry-wide Edge Router and Switch growth of just 3.6% in 2013 (Dec 13th report). EZchip is not blind to this trend, it has dramatically rebranded its last three investor presentations (Q3, Q4, and Roth), shifting emphasis from Carrier Ethernet to NPS/Smart Networks. Unfortunately, shareholders won’t see NPS revenue until 2016+, if ever.
The Question of Stock-based Compensation
Other industry analysts, such as Paul McWilliams of Next Inning Technology Research, challenged our decision to expense stock-based compensation (“SBC”) in EZCH’s forward EPS projections. Ours is not a radical idea, and Generally Accepted Accounting Principals (GAAP) mandate that SBC be expensed from EPS in all SEC filings. To justify EZCH’s add-back and non-GAAP EPS reporting, as used in Wall Street projections, it has been argued that future cash flows will be used to purchase newly-issued, dilutive stock. We completely disagree with this concept. Investors pay 18x 2013E EBITDA for EZCH stock because they expect to have a claim on future cash flows. If that future cash isn’t value additive, and is instead used to correct for past SBC excesses, the earnings multiple used to value EZCH should be materially lowered. In light of this, it makes sense that GAAP dictates that stock-option expense is recognized on the income statement at the time of grant.
While the effect of this dilution creeps up slowly, ensuring that investors barely notice, it can have a drastic impact over an extended period. Over the past four years, EZCH’s fully diluted share count has climbed from 23.6m to 29.6m today, resulting in 25% dilution for investors who first purchased the stock at the end of 2008.
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While this track record of steady dilution presents serious red flags for long-term holders of EZCH shares, it’s doubly egregious when investors are also being misled into believing that non-GAAP financials are indicative of financial performance. In 2012, EZCH reported a 49% non-GAAP net income margin (Q4 Presentation, Slide 14), a figure that is frequently cited by bullish investors and the sell-side analysts. After correcting this figure for 2012’s $11.2m of stock-based compensation expense, the margin falls precipitously to 29% (15.902 / 54.707). This is no rounding error. It reminds us that investors need to be vigilant for excessive non-GAAP earnings adjustments.
Conclusion
While entrenched bulls argue that EZCH has zero competitive threats, we continue to believe that Broadcom’s more complete networking product line (NPUs, switches, KBPs, multi-core processors, etc.) and lower cost base is a competitive advantage versus EZchip. Cisco’s success over Juniper is illustrative of the benefits of scale. One could argue that Cisco was able to take share from Juniper because Cisco offered a wider swath of products at discounted prices. EZCH could face a similar competitive dynamic from its newly emerged larger competitors.
Equally as important, even if EZCH is successful in retaining its current customers, we expect that the presence of alternatives such as BRCM will allow Cisco and other customers to pressure EZCH on pricing and other terms. Given its high customer concentration, the ability for customers to produce NPU chips in-house if they desired to allocate the requisite internal resources, and the presence of competitors like Broadcom, we think that EZCHwill perpetually have limited pricing power for its products.
At EZCH’s current market capitalization of over $700m, we believe the market remains too optimistic. Revenue expectations for the next two years are $69.7m (2013) and $94.2m (2014), requiring a 31% YoY CAGR, well in excess of the 3.6% Edge Router/Switch end-market growth forecasted by Gartner (December 13th, 2012 report). Revenue growth of 30%+ requires EZCH to fend off Broadcom and in-house ASIC competition, have its product mix drastically shift towards higher-priced NP-4, and be able to add new business from Ericsson, Tellabs, and Huawei. If any one of these levers fails to deliver, EZCH will likely see another year of moribund growth and disappointed shareholders.
Disclosure: We are short shares of MLNX. Please click here to read full disclosures.
Mellanox (MLNX), a stock that we've previously written up as a short recommendation, announced disappointing Q4 2012 results yesterday and gave catastrophic Q1 2013 revenue guidance. Though the stock initially dropped 22% after hours to $41, MLNX shares eventually rallied to $51 signifying a mere 1.4% decline for the day. Given three quarters of massive revenue declines ($157m in Q3 2012, $122m in Q4 2012, and ~$80m for Q1 2013) this is a stock that should be trading at a much lower level. With analysts having issued downgrades en masse and no longer supporting the stock with blind optimism, MLNX should reverse its intraday gains and fall to the $30s.
Valuation Remains Much Too High
Today at $51, shares of MLNX remain highly overvalued.
First, Mellanox clearly no longer deserves a premium valuation multiple. Business fundamentals have been suffering a steep decline over the past few quarters. The company's Q1 2013 revenue guidance of $77 - $83m is well below the $89m of revenue made in the first quarter of last year. The forecast represents a 34% decline from the fourth quarter, and missed analyst estimates of $130m by a stunning 40%. As we summarize later in this article, the company's 2012 growth was the product of the Intel Romley upgrade cycle, and with the cycle having now turned, investors are reminded that Mellanox is simply yet another cyclical semiconductor company. As a result, we assume a 15x earnings multiple, comparable to the multiples of a peer group of Emulex (ELX), Brocade (BRCD), and QLogic (QLGC). These analogous interconnect businesses have modest growth expectations, as MLNX investors should come to expect, and somewhat commoditized product offerings, which high-speed Infiniband will soon become.
We will discuss later in this article why even this 15x earnings multiple is highly optimistic, since there is a strong chance that MLNX's high-end Infiiniband business will be rendered extinct by Intel (INTC) within the next five years.
Having determined an appropriate multiple, let's next examine Mellanox's 2013 figures. Management has not provided guidance beyond next quarter, and analysts have yet to digest the company's stunning 40% revenue miss and issue new estimates, so we'll make some basic assumptions. If we optimistically assume that Mellanox actually meets its quarterly guidance for the first time in over six months, then the company would earn an annualized $320m in revenue in Q1. Let's assume some growth in subsequent quarters and therefore 2013 revenue of $400m. At a 20% net income margin (Q4 2012 was only 15% on a GAAP basis and historical years prior to 2012 witnessed profit margins under 10%), the company would report earnings per share of about $1.70. At our 15x P/E multiple, generous in light of the potentially terminal nature of MLNX's business, we'd assign $26/share of value to the earnings stream. The company holds $9/share of net cash, but smallcap semiconductor companies have a poor history of returning cash to shareholders and MLNX has never paid a dividend or repurchased shares, so we only give credit to 25% of that cash.
Adding $2/share of net cash to $26/share of business value and rounding up gets us to a fair value of about $30/share, a 40% discount to the current price. Below is a table summarizing our calculations.
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Yet even at $30, owning MLNX shares remains highly risky. That's because there's a good chance that Intel's next-generation CPU+Interconnect design will render MLNX extinct within 5 years. As such, we took the opportunity to materially increase our short position after yesterday's irrational intraday short covering rally. Below is an intraday graph of yesterday's price action:
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Source: Yahoo Finance, January 24th, 2013.
The Stock has Lost the Support of the Sellside
After its surprisingly strong growth in the first half of 2012, analysts rushed to outdo one another with $140-$150 price targets and ebullient Buy recommendations. Since most analyst models simply projected quarterly revenue using straight-line growth assumptions, infectious optimism quickly enveloped this momentum stock. Even at its peak price near $120 on September 6, MLNX was awarded Buy ratings by the majority of the analyst community and price targets were dutifully increased as the stock ticked upwards. Below are Bloomberg analyst ratings from September 6.
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Source: Bloomberg Analyst Ratings, September 6, 2012.
Times have changed. After Wednesday's Q4 2012 earnings call, many analysts finally recognized their folly. What was once a sea of green 'Buys' is now overwhelmed by 'Holds', which is actually a code word for 'Sell' on Wall Street.
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Source: Bloomberg Analyst Ratings, January 24, 2013.
The once flowery praise has been replaced with scorn:
"Further exacerbating the impact of weak guidance, management's tone and demeanor was off-putting and at times seemingly evasive as it "stonewalled" analyst attempts to garner additional color into specific details surrounding the weak guidance…we believe management has significant work ahead to restore investor confidence."
- Wunderlich Securities "Stunned, Stonewalled, and Sandbagged," January 24th, 2013
"We thought we'd seen everything, but apparently we hadn't…The guidance for the first quarter of 2013 is catastrophic - $78-83 million… the company has almost no control over demand or influence on OEM customers to buy from it…There is no question that rebuilding capital market confidence will be protracted and arduous." - DS Brokerage, January 24th, 2013
The white-shoe investment banks were more gentle about their disappointment, but the overall tone was negative nonetheless:
"We are lowering our TP to $40.00 from $55.00…we believe the market needs to see a path back to $150m/quarter run-rate before any meaningful appreciation in stock price - hence, we remain Neutral."
- Credit Suisse "Growth Hibernates for the Winter," January 24th, 2013
"Given the sell-off from the peak, negative sentiment, and our anecdotal sense that many investors appear to have moved to the sidelines, we expect the shares to settle in the $40s with support from the ~$10/share in cash."
- Barclays "Resetting the bar," January 24th, 2013
Once a company loses the confidence of the sellside, it usually becomes much more difficult to win back. Analysts won't want to risk their reputations on a stock that has already burned them once before.
Will Mellanox Be Around in Five Years?
During the September 11-13th Intel Developer Forum, Intel officially announced its intention to integrate its next-generation CPU with an interconnect device, theoretically cutting out the need for a third-party interconnect provider like Mellanox. Intel's intent was mentioned by multiple press sources and presentations from Intel's technical sessions on the topic are available online. By assembling interconnect technologies and engineering teams from Cray, QLogic, and Fulcrum, Intel should be well positioned to complete its task. But even if Intel doesn't meet its timeline goals, the chipmaker controls the CPU design, allowing it to build a design that only functions optimally with an Intel's interconnect. This integration could potentially provide power and performance synergies as well as cost savings for the end-users. It would also completely box Mellanox out of the high-end HPC (high-performance computing) market.
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Source: Intel Developer Forum, Diane Bryant, September 11th, 2012
When asked about this threat from Intel in the third quarter conference call, the Mellanox CEO essentially had no viable solution, admitting that Mellanox would have no choice but to "find the right way to work with them or to compete with them". In other words, Mellanox has little influence on whether Intel will render the company's products obsolete.
The full discussion from the call is below:
<Dan Harverd, Deutsche Bank AG, Research Division>
And then just a final question, a longer-term question. We've seen Intel during the quarter for that roadmap for its plans and InfiniBand, and potentially interconnect control into CPU. Could I get any thoughts on that and how that would affect your business going forward?
<Eyal Waldman, MLNX Executive Chairman, CEO, and President>
Obviously, we are working with Intel in multiple dimensions. Intel will try to come out something in the 2015, '16 time frame with their 100 Gigabit per second solution. It's yet to be seen how we work together if we work together at that time frame. And obviously, Mellanox, we continue to develop our own solutions for the 100 Gigabit per second, which we think will come out in 2014 time frame, so we still hope to continue leading this market and keep taking market share away from our competitors.
<Dan Harverd, Deutsche Bank AG, Research Division>
And if they were to come up with an integrated product, would that change -- how would you see that changing the fundamentals of the market?
<Eyal Waldman, MLNX Executive Chairman, CEO, and President>
Well, then we'll find the right way to work with them or to compete with them.
If Intel builds an interconnect solution into its next generation of high performance computing CPUs, there probably is no "right way" for Mellanox to work with them or compete with them.
Why Mellanox no Longer Deserves a Premium Multiple
Our initial report on September 10th, 2012 questioned the Street's overly simplistic growth assumptions and probed for more concrete answers to explain the company's rapid good fortune. Based on our research, Mellanox's growth was attributed to high-performance computing customers who were paying up for the premium priced 56GB/s FDR Infiniband in order to fully utilize newly installed Intel "Romley" CPUs. We felt that this Romley uptake cycle would soon wane and predicted that the straight-line revenue assumptions for Q4 2012 and early 2013 were flawed.
After the third quarter earnings call, MLNX's CEO mentioned "a revenue baseline of $150 million," a figure that was quickly latched onto by analysts hoping to construct their two-year models. On the same call, the CEO also warned, "you know again, we don't give guidance or visibility more than one quarter" yet appeared to acquiesce when analysts inferred that $600m would become the annual revenue baseline and the de facto worst case scenario for the Street's models. Investors continued to trust the company even after the management gave underwhelming Q4 guidance on their October 17th third quarter call. Q4 revenues were projected at only $145m - $150m, implying a sequential decline in revenue of 6% that was well below growth expectations. Those who followed the story closely noticed a second chink in the armor when the newly installed CFO revealed MLNX's complete lack of end-market visibility at a November 14th UBS conference, stating, "we said that $150 million is a baseline. That's purely based on our gut feeling [Emphasis added]."
After that comment, we were stunned that the analyst community continued to take guidance from management at face value. In contrast to the analyst expectations of September 2012, when $150m of run-rate quarterly revenue was considered the floor and consistent sequential growth was the expectation, it's clear that MLNX's ephemeral revenue boost was the result of the Romley uptake cycle and not a sustainable trend.
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Source: Capital IQ, MLNX earnings calls and filings (10K, Q4 2012 8K).
Our chart from the September 2012 report shows that the revenue shortfall has essentially matched the predicted demand from the Intel server ramp cycle.
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Source: Jefferies Research note on IPHI, February 1st, 2012.
Given this relatively straightforward explanation for the recent revenue shortfall, we believe that the guidance for Q1 2013 is more indicative of what revenue will look like throughout this year. This should be exacerbated by the increased uptake of 40GB/s Ethernet, which has a much lower price point than 56GB/s Infiniband.
Broadcom (BRCM), a leader in 40GB/s Ethernet, explained this during a Deutsche Bank conference in September:
"And [the HPC] market, as you know, there's a natural transition happening in speeds, going to 56 Gb Infiniband as the Romley cycle comes on…And that's been [MLNX's] traditional market. There's been some adoption of Infiniband in other markets, right. Also, they talked about a large cloud customer, and they also talked about some increasing need for storage cluster for the back end. And if you look at those markets, for the most part it's a pricing game and a density game between Ethernet and Infiniband, right? So today, we have 56 Gb Infiniband in the market…And now with Trident II -- by the way, 40 Gb Ethernet is going to start shipping and going after exactly the same market that they're in right now. Now the end customers have a choice, right. They can go buy…from Mellanox, or they can go buy 40 Gb Ethernet switches that do essentially the same thing from 10 different providers, with an open ecosystem and standards-based interoperability that they don't have to worry about. So to me…[Ethernet providers are] going to be in a good position to go back out there and make sure that all the business that's on Ethernet remains on Ethernet versus going to Infiniband."
We think that this rapid influx of 40GB/s Ethernet into the much more cost-conscience Web 2.0, cloud, and storage markets will prevent MLNX from growing meaningful beyond their HPC customer base.
Conclusion
Ultimately, Mellanox is a company with dramatically declining 2013 revenue and profitability, a management team that has lost credibility with the sellside, and a core product line that may be rendered obsolete by Intel. It does not deserve a 6x forward revenue multiple or 30x P/E multiple. Having lost its growth / momentum investor base due to large earnings misses and rapidly declining investor sentiment, the current inflated stock price is mostly the product of yesterday's short covering rally. Such rallies are often fleeting, and MLNX shares could soon resume their steady descent.
DISCLAIMER: WE ARE SHORT MLNX AND BENEFIT TO THE EXTENT THE PRICE DECLINES. THIS IS NOT A RECOMMENDATION TO BUY OR SELL SECURITIES. WE MAY TRANSACT IN SHARES OF MLNX SUBSEQUENT TO PUBLICATION.
Disclosure: We are short shares of MLNX. Please click here to read full disclosures.
Mellanox’s third quarter earnings report, released yesterday after the market close, has given us an opportunity to provide an update on the situation. While the Company’s third quarter top-line results were slightly above analyst estimates, beating revenue guidance by 3.5% ($156.5m actual vs. $153m consensus), the Company’s fourth quarter guidance severely underwhelmed expectations. Towards the end of the prepared remarks, Mellanox’s outgoing CFO gave Q4 revenue guidance of $145m - $150m, indicating a sequential fall in revenue from Q3. As a company that traded at 8x forward revenue just before the earnings call, the anticipated slowdown in Mellanox’s revenue is catastrophic. This is particularly true because MLNX is undoubtedly a fast-money growth stock. Even worse, Mellanox expects a Q4 increase in non-GAAP operating expense of 6% - 8%, indicating that earnings per share will be hit by a double-whammy of lower revenues and rising costs.
After investing significant time and resources to analyze past trends of the server component industry, we were fortunate enough to anticipate this slowdown in our September 11th, 2012 Mellanox short post. We have been rewarded with a drop in Mellanox’s share price from a high of $120 to $78 (inter-day). Equally as important, our returns were the result of a thesis proved correct rather than a lucky occurrence. The disappointing Q4 guidance was due to an inevitable slowdown from Mellanox’s high-performance computing (“HPC”) customers. These HPC customers initiated an upgrade cycle in Q1 2012 following the release of Intel’s Romley platform, driving demand for Mellanox’s FDR 56 GB/s interconnect. Neither the Wall Street community nor MLNX management was willing to acknowledge this cyclical trend, providing us with an excellent investment opportunity. A chart from our September report explicitly identified the potential of a Q4 2012 slowdown, as shown below:
On the Q3 earnings call, Mellanox’s CEO, Eyal Waldman, admitted the connection between Mellanox’s stratospheric growth and the Romley upgrade cycle, “In Q4, without any Romley pent-up demand or individual large deals, our guidance implies a revenue baseline of $150 million.” Most equity research analysts were caught off-guard by the guidance announcement and spent the majority of the Q&A examining the linkage between prior growth and Intel Romley.
<Q - Analyst>: Good afternoon. So, could you give a little more clarity on the three deals in the third quarter? Were those all HPC-related? And then, so basically in the fourth quarter, HPC is going to be down sequentially?
<A - Eyal Waldman [CEO]>: Most of them were HPC oriented. And, Q4, we don't see significant large deals that we've seen due to the Romley pent-up demand, and we're actually pretty happy to see that we're still staying with a baseline of $150 million.
<Q - Analyst>: …I was wondering if you could – and I know it's an important driver, but backing out some of the big deals, Romley, as a percentage of your business, what is that doing sequentially? What was it in Q3? And what do you expect it to contribute in Q4?
<A - Michael P. Gray [CFO]>: I mean, the most visible metric for us… is the percent of our business that's 56 Gigabit because 56 Gigabit has been engineered to get the most out of Romley. And that did grow sequentially in terms of percent of our revenues. It grew from 54% of our revenues in the second quarter to 57% of our revenues in the third quarter.
In the instance of Mellanox, we believe that Wall Street research analysts, many of which justified their Mellanox BUY recommendations with 30x or 40x forward P/E multiples, were overly reliant on backward-looking financial analysis and hard to quantify ‘cloud computing’ and ‘Web 2.0’ buzzwords. Some of them will go through great effort to spin these results in some sort of positive light. But make no mistake about it; MLNX is not the stock that many growth investors thought it was. As such, we expect a further re-rating of the Company’s valuation multiples going forward.
DISCLOSURE
WE ARE SHORT MLNX AND STAND TO PROFIT FROM A DECLINE IN THE STOCK PRICE. WE MAY TRANSACT IN MLNX SECURITIES SUBSEQUENT TO THIS POST. THIS COMMUNICATION IS FOR INFORMATIONAL AND EDUCATIONAL PURPOSES ONLY AND SHALL NOT BE CONSTRUED TO CONSTITUTE INVESTMENT ADVICE. NOTHING CONTAINED HEREIN SHALL CONSTITUTE A SOLICITATION, RECOMMENDATION OR ENDORSEMENT TO BUY OR SELL ANY SECURITY OR OTHER FINANCIAL INSTRUMENT OR TO BUY ANY INTERESTS IN ANY INVESTMENT FUNDS OR OTHER ACCOUNTS. THE AUTHOR HAS NO OBLIGATION TO UPDATE THE INFORMATION CONTAINED HEREIN AND MAY MAKE INVESTMENT DECISIONS THAT ARE INCONSISTENT WITH THE VIEWS EXPRESSED IN THIS COMMUNICATION. THE AUTHOR MAKES NO REPRESENTATIONS OR WARRANTIES AS TO THE ACCURACY, COMPLETENESS OR TIMELINESS OF THE INFORMATION, TEXT, GRAPHICS OR OTHER ITEMS CONTAINED IN THIS COMMUNICATION, AND ALL COMMUNICATIONS IS PRESENTED “AS IS”. THE SENDER EXPRESSLY DISCLAIMS ALL LIABILITY FOR ERRORS OR OMISSIONS IN, OR THE MISUSE OR MISINTERPRETATION OF, ANY INFORMATION CONTAINED IN THIS COMMUNICATION.
