Don't Buy Misguided Bet on Mellanox

NEW YORK (TheStreet) -- Everything is relative in the stock market. And sometimes expectations have more to do in determining success than a company's actual performance.

To that end, when compared to last year's 25% gains of the S&P 500, chip-related stocks, which added (just) 20% to investors' portfolios, were a relative disappointment. But Mellanox (MLNX) investors can only wish this company was as "unfortunate."

Due to (among other things) the company's industry-leading data center and storage technologies, Mellanox was one of the industry's best performers in 2012. Everything then was about "Big Data" and how the storage cloud would take over enterprises. The Street salivated over the company's growth potential, while rewarding the shares with higher valuations.

Unfortunately, Mellanox couldn't deliver the goods in 2013. With the stock price declining 33% for the year, the company was a notable underperformer. But that hasn't stopped the Street from hopping back on the bandwagon. After recent meeting with the company's management, analysts at Stifel, which has a $55 price target on the stock, see Mellanox benefiting from a rebound in the HPC (high-performance computing) market as well as in the company's other segments.

This optimism was followed by Maxim Group analyst Ashok Kumar, cited the company's "InfiniBand" high-speeding networking standard and raised his rating on the stock to buy from hold. Kumar believes that Mellanox can "hold its own" even amid competitive threats from rivals whose platforms are based on the Ethernet standard.


That's all well and good. But these were the same "buy reasons" cited at the onset of 2013. Given the modest macroeconomic improvements, I don't expect Mellanox to duplicate last year's horrid performance. Even so, there is no evidence that demand will get significantly better. At least not to the extent that it supports 30% share price increase, as suggested by Stifel's $55 price target.

I don't dispute that there's a chance things will get better. The thing to remember here is that any meaningful growth is hinged upon the success of some of the company's biggest customers, which includes Hewlett-Packard (HPQ) and IBM (IBM). These are great names, yes. But their best years have passed them by. And they haven't been top performers lately in the critical data center/storage markets.

With those markets in a perpetual decline, it seems premature to assume that Mellanox has seen the worst. And let's say those markets do recover, or stop declining, Mellanox still has to answer to threats from market leaders like EMC (EMC) and NetApp (NTAP). Add Brocade (BRCD) and possibly Cisco (CSCO) to the mix and you have a room of growth-hungry rivals competing for shrinking pie.

With the field so saturated, I don't believe the pie slice Mellanox might get jives with the growth expectations presumed by 657 P/E. And that's not a typo, either. That's 32 times the multiple of EMC. And if we're to appraise Mellanox closer to other underperforming chip companies like Broadcom (BRCM), Mellanox -- despite having half the operating margin of Broadcom -- still carries of premium multiple of 20.

Wednesday, the company will report fourth-quarter earnings and unlike last year, management must deliver on this optimism. The Street will be looking for 20 cents in earnings per share on revenue of $107.85 million. Investors seem encouraged that this would be a sequential increase of 3.6%. But let's not forget it also implies a year-over-year decline of close to 12%.

The optimistic view will argue that the 12% decline (if reached) won't approach the 33% decline posted in the October quarter. Regardless, that's still not enough basis to buy these shares today. And with such high expectations and "worse case scenarios" priced into the stock, investors can only hope that management delivers in a manner that suggest customer demand will pick up. And given that IBM's just issued weaker-than-expected outlook, that's not a bet I'm willing to place.

At the time of publication, the author held no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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