Mellanox Technologies, Ltd. (MLNX): Potential Return Of HPC Buyers Could Boost Topline

Shares of Mellanox Technologies, Ltd. (NASDAQ: MLNX) have fallen 54 percent in the last one year. However, the company could see potential upside from the return of hyperscale high performance computing (HPC) buyers driven by Intel's Grantley later next year, more storage market sales required due to flash, and Ethernet switch share gain helped by open source Layer 3 software.

Mellanox Technologies is a leading supplier of end-to-end InfiniBand and Ethernet interconnect solutions and services for servers and storage. Mellanox interconnect solutions increase data center efficiency by providing the highest throughput and lowest latency, delivering data faster to applications and unlocking system performance capability.

Yokneam, Israel-based Mellanox sells InfiniBand and Ethernet networking switches, adaptors, chips, cards, and cables. Mellanox's products are high-performance and target a number of markets including HPC, enterprise data centers, Web 2.0, and financial services.

"For the stock to work at 18x next year's EPS some proof of the pudding is required. Evidence, in the form of improving top-line growth, is needed," UBS analyst Steven Milunovich said in a client note.

There are various sources of sales. The first would be the release of Intel's Grantley chips. Intel's Grantley chipset, due out in the second half of 2014, is needed to get the cyclical portion of the high-performance computing business going (hyperscale clusters). This could be roughly $50 million -$70 million in extra FDR (faulty device replacement) sales.

In addition, Mellanox's 100Gbps InfiniBand release in 2014 or 2015 could ignite a full HPC refresh, which would include hyperscale cluster users and possibly an extra 50 percent of baseline business.

Layer 3 open source software for Mellanox's nascent Ethernet switch business is coming. It's unclear how much share Mellanox could grab, but the opportunity is large. Gartner estimates that 10GE accounted for 33 percent of the $18 billion enterprise ethernet switch market in 2012.

"Mellanox has had a number of design wins for the back end (inside) of storage arrays—we think nearly all of its roughly $80mn in run-rate storage sales is back end. Getting InfiniBand on the front end could accelerate sales," Milunovich said.

Mellanox estimates the front-end storage market to be $1.3 billion today. Higher speed arrays! (like all-flash) should push customers to InfiniBand. Moreover, private and public cloud and Web 2.0 are moving to InfiniBand slowly, which could accelerate if more lighthouse accounts endorse InfiniBand.

Microsoft (MSFT), salesforce.com (CRM), EMC's Pivotal, and Oracle (ORCL) have gone public with their use of InfiniBand. Mellanox's support for OpenStack could help.

"We believe the growth in storage, Web 2.0, and cloud is being hidden by the cyclical drop in HPC, which is about half of revenue. Growth should return in later 2014 when Intel's Grantley ships and could be turbo-boosted in late-2014 into 2015 if Mellanox can deliver 100Gbps," Milunovich noted.

The key to Mellanox's success is improving interconnect speed and reliability. Wire speed is how fast the physical layer can move bits. Mellanox is the fastest today at 56 Gbps and is working hard to get to 100 Gbps before anyone else. The acquisitions of Kotura and IPtronics will enable Mellanox to control the complete vertical stack.

Meanwhile, RDMA (remote direct memory access) could provide upside for Mellanox. RDMA, which can be used with both InfiniBand and Ethernet, will see widespread adoption. RDMA over Ethernet even has a catchy marketing name—"rocky"—for RoCE (RDMA over Converged Ethernet).

"Mellanox is the leader is RDMA, the remote nature is the new element since DMA has been around for decades. By remotely putting data into another application's buffer, the system becomes much more efficient," Milunovich said.

CPUs don't have to spend as much time handling data transfers and waiting for results. Tests show CPU efficiency can jump from 53 percent to 88 percent. The growth of enterprise flash will require faster networks to deliver the promised speed improvements of flash.

Disk drive latency is typically 6,000 microseconds while the typical SSD is 25 milliseconds. By using RDMA, the latency drops all the way down to 46 ms (a 136-fold improvement).

As a result, for the stock to work, h! igh-perfo! rmance computing (accounts for half of the revenue) needs to improve. This is expected in the second half of 2014 with the release of Intel's Grantly chip. Storage is now the second largest segment bolstered by flash and also could boost sales.

"For 2014, we project a 27% revenue increase to $500mn accompanied by substantial operating margin improvement from 11.5% to 19%, resulting in $2.00 of earnings," Milunovich added.