The Company Dominating the Semiconductor Business

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Mellanox Technologies (NASDAQ: MLNX) is fabless semiconductor company that supplies interconnect products for computing, storage, and communication applications in the computing, Web 2.0, storage, financial services, database, and cloud markets. Although it is relatively young (formed in 1999), this company has huge potential and has seen its stock soar 97.7% YTD, all the more interesting considering Mellanox, with a $2.6B market cap is by no means a small-cap company. So, what is behind Mellanox's huge run, and more importantly, does Mellanox's stock still have significant upside potential? 

Positives

One of the most significant things working for Mellanox right now is its close partnership with industry bellwethers. In 2010, Oracle (NYSE: ORCL) made an investment in Mellanox by acquiring 10.2% of the company to solidify a "long term strategic relationship" between the companies. Additionally, on June 11, 2012, Intel (NASDAQ: INTC) announced that it will use Mellanox's Infiniband adapter chips in its half-width server boards and I/O Expansion modules supporting its Romley servers. This positive development has the potential to  have a significant impact on Mellanox's revenue growth in the future. 

Mellanox's signature product, the Infiniband, also occupies a huge niche in the area of data networking. Infiniband is superior to its main product rival, Ethernet: InfiniBand has consistently offered lower latency, more bandwith, lower power consumption, and lower cost-per-port than Ethernet. Moreover, Infiniband is widely considered to be by far the fastest and most efficient switch fabric for running enterprise data centers. According to Oracle CEO Larry Ellison, "Mellanox has been instrumental in maintaining InfiniBand's immense competitive lead over Ethernet." This competitive advantage is one of the main reasons for Mellanox's growth and will continue to ensure Mellanox's dominance in the semiconductor industry, at least in the short term.

Despite the significant competitive advantage of Mellanox's Infiniband and its cozy relationship with Intel, Mellanox has by no means rested on its laurels. In fact, Mellanox has been aggressively expanding its capabilities and diversifying its customer base. On February 7, 2011, Mellanox announced the acquisition of Voltaire, a supplier of high-performance, end-to-end connectivity solutions for data center servers and storage systems, for $208 million. This acquisition is expected to solidify Mellanox's market leadership position as the premier provider of end-to-end connectivity systems and open up new data center markets for Mellanox. Also, on May 21, 2012, Mellanox announced that  its InfiniBand and 10G/40G Ethernet modules are available for use with HP's ProLiant servers. HP (NYSE: HPQ) is the world's No. 2 server vendor and this alliance will help Mellanox reduce its dependence on Oracle's high-end systems. 

Negatives

The semiconductor industry, one of the least stable industries of all, is cyclical and subject to rapid change. Moreover, the semiconductor industry is extremely competitive and cutthroat. As noted in its 2011 annual report, Mellanox points out that the industry can also be significantly impacted by economic volatility and challenging economic times. 

Also, Mellanox depends on a small number of large customers for a a significant portion of its sales. Sales to its Top 10 customers accounted for 71% of Mellanox's revenues. In fact, HP and IBM (NYSE: IBM), by themselves, accounted for 19% and 17% of Mellanox's revenues respectively. Mellanox notes that, "Our customers, including our most significant customers, are not obligated by long-term contracts to purchase our products and may cancel orders with limited potential penalties." Although Mellanox's Infiniband is superior to similar competitors as of now, Mellanox needs to maintain its advantage into the future or else it faces the risk of losing a significant portion of its revenue as major customers embrace superior alternatives.

The Verdict

Mellanox has seen explosive growth as its Infiniband system is adopted by more vendors and, in the near term, will most likely continue to post strong revenue and profit growth. Mellanox has significant upside potential, especially considering its partnerships with Intel and HP as well as the current superiority of the Infiniband over its competitors. However, in the long term, Mellanox's prospects are less clear due to the competitive and rapidly changing nature of the semiconductor industry. 


Bilifuduo has no positions in the stocks mentioned above. The Motley Fool owns shares of Intel. Motley Fool newsletter services recommend Intel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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