Stop and Think Before Selling These Leaders

Robert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Investors have been a little trigger-happy lately, hitting the sell button on any hint of changing trends at their companies.  While your broker certainly enjoys the business, trading on emotion isn’t likely to do too much for your portfolio.  Businesses usually aren’t built or destroyed overnight, so investors need to separate short-term fluctuations from long term trends.  Let’s look at two situations.

The rise of InfiniBand

Shareholders of Mellanox Technologies (NASDAQ: MLNX) have been on an uncomfortable roller-coaster lately, as the company’s share price has declined over 50% since August 2012.  Mellanox has been growing very fast recently, with a 208.3% increase in revenues over the past four fiscal years.  However, potential competition from industry giant Intel and delayed orders have led some analysts to question its growth trajectory.

Founded in 1999, Mellanox manufactures semiconductor products that allow servers in data centers to work more efficiently and with greater stability.  It has been one of the chief proponents of InfiniBand, a technology architecture that competes with widely-used Ethernet.  Mellanox’s sales have benefited from soaring demand, as its data center customers deal with the huge volumes of transactions that have resulted from the growth in online business and cloud computing activities.

In its latest quarter, Mellanox reported increases in revenues and adjusted operating income of 68.0% and 152.8%, respectively, versus the prior-year period.  The company benefited from its outsourced business model, which allowed it to generate higher gross and operating margins during the period.  While management has noted some softness in orders during its last two conference calls, the insatiable demand for cost savings and energy efficiency in the data center environment should lead to strong future demand for Mellanox’s products.  With $400 million in cash and a reasonable 15 P/E multiple, Mellanox is positioned for success.

The Cupertino giant

Meanwhile, shareholders of Apple (NASDAQ: AAPL) have been on a similar downward slope lately, with the company’s share price down 30% since August 2012.  Despite growing its revenues by 317.5% over the past four fiscal years, Apple is valued at only a 10 P/E multiple.  With competition on all fronts, including a high-profile legal tussle with Samsung, investors question whether the company can continue to deliver strong growth without founder Steve Jobs.

In the first quarter of FY2013, Apple reported a 17.7% increase in revenues, but operating income fell 0.8%.  Its iPhone and iPad shipments rose sharply, while Mac shipments fell as a result of weak PC sales across the industry.  Product prices were generally flat versus the prior year, although the iPad segment exhibited declining prices due to the introduction of the less-expensive iPad Mini during the period.  More importantly, gross and operating margins contracted as a result of the customer shift toward phones and tablets, as well as the need to continually invent exciting, new products.

Many of Apple’s products have enjoyed premium prices versus competitors’ products, leading to a high operating margin that still exceeded 30% in the first quarter of FY2013.  At the company’s current size of roughly $150 billion in annual sales, it will be hard to maintain profitability at the current level across its diverse, ultra-competitive markets.  With $130 billion in cash and a low valuation, though, Apple has a nice margin of error to build or buy businesses that will add to its intrinsic value.

When to worry

Naturally, there is a time and place to act upon trends that are negatively affecting your investments.  When customer purchasing habits permanently alter your company’s prospects, it's time to find the exit.  Best Buy (NYSE: BBY) and RadioShack (NYSE: RSH) are good examples of such a shift.

Both companies operate thousands of stores, primarily in the U.S., that sell a wide range of consumer electronics and mobile devices.  While the companies’ national base of stores were previously an advantage, they have since become a source of additional, uncompetitive costs.  Customers have increasingly used stores to browse their favorite electronic products, but have purchased the items directly from manufacturers’ websites or through online marketplaces.

In FY2012, both companies reported small declines in total sales, but large shortfalls in operating income that didn’t support their required capital needs.  Best Buy’s more diverse product mix allowed it to perform relatively better, but both companies reported declines in comparable store sales.  Smartphones account for a large portion of both companies’ sales, but the products ironically have a low profit margin to the resellers.  While both companies are attempting to use their websites and service offerings to increase sales, they have a long, uphill climb to remake their businesses in the digital age.

The bottom line

Apple and Mellanox are leaders in their industries and have shown abilities to provide innovative products that are in high demand from their customers.  While their businesses may have short-term hiccups, the long-term business trends support these companies' growth well into the future.  At low valuations, they are companies to own.

rghanley owns shares of Mellanox Technologies and Apple. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple and RadioShack. The Motley Fool is short RadioShack. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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