Nvidia: The Acquisition Of Mellanox Increases Risks

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About: Mellanox Technologies, Ltd. (MLNX), NVDA
by: Hervé Blandin
Summary

Nvidia announced the acquisition of Mellanox with a cash transaction of $125/share.

The deal expands Nvidia's portfolio in the data center but the medium-term synergies are limited.

The acquisition is a long-term bet on the integration of GPU and interconnections technologies in the data center.

The price of the acquisition is fair for both parties. But Nvidia's risk profile increases.

Nvidia (NVDA) announced the acquisition of Mellanox (MLNX) for an enterprise value of $6.9 billion. Although the deal expands Nvidia's portfolio in the data center segment, medium-term synergies are limited. The competition with Intel (INTC) will increase. And Nvidia will start competing with other dominant strong players like Cisco (CSCO) and Arista (ANET).

Beyond these challenges, the acquisition is a long-term bet on the integration potential between the GPU and the interconnection technologies of the two companies.

Considering the uncertainties of achieving such a long-term goal, the price for the acquisition represents a risky bet for Nvidia's shareholders.

Deal between Nvidia and Mellanox Image source: rawpixel via Pixabay

Intensifying competition

On the surface, the acquisition of Mellanox by Nvidia makes sense from an operational perspective. Both companies propose HPC (High-Performance Computing) solutions for the data centers.

But the businesses are actually different and the companies don't compete. Mellanox sells hardware that interconnects devices in the data center (network cards, switches, cables, etc.). The table below summarizes the revenues Mellanox realized over the last two years across its different segments.Mellanox: 2018 revenues per segment

Source: 10-K 2018 Mellanox

The "Boards" segment, which corresponds to network cards, is the most important business in terms of revenue and growth.

Nvidia doesn't sell any interconnecting equipment. Instead, the company sells GPUs and related software to different markets (gaming, data centers, etc.). The acquisition is only about the data center business, though.

As shown below, the data center segment represented only 25% of total Nvidia's revenue. But this business grew 51.8% year-over-year.

NVidia revenue per segment

Source: 10-K fiscal 2019 Nvidia

Considering the different businesses of the two companies in the data center area, the synergies are not obvious. Management was honest about it:

"Importantly, the proposed acquisition is about accelerating innovation, rather than cost synergies." - Source: FAQ Mellanox acquisition

The rationale for the acquisition is a long-term vision of the data center architecture where the data processing and interconnections technologies are more and more integrated.

Today, with independent technologies, Nvidia and Mellanox equip the two most powerful supercomputers in the world, according to the TOP500's ranking.

Top 2 supercomputers with NVidia and Mellanox technology

Source: top500.org

Nvidia will expand its data center portfolio with this deal. But the competition with Intel will intensify. Besides the rivalry for the CPU/GPU market in the data center, Nvidia will compete with Intel in the data center Ethernet card market.

According to a report from Crehan Research, Intel is the leader in the high-speed Ethernet adapter and controller business with 60% of total volumes during Q2 2018. The report also indicates Mellanox dominates the 25GbE+ Ethernet adapter market with a market share of over 70%.

Also, in the latest 10-K, Mellanox mentioned:

"we work with leading vendors across related industries, including: processor and accelerator vendors such as AMD, ARM, IBM, Intel, Nvidia, Oracle, and Qualcomm;"

With this deal, it remains to be seen if AMD (AMD) and Intel will still cooperate in the same way when Mellanox belongs to Nvidia.

And with Mellanox also comes the data center switches business. Nvidia will become a competitor of Cisco and Arista in this market. Both network vendors operate at a much higher scale and have an important market share in this area. The graph below shows Cisco and Arista reach about 66% of the data center's market share for 10G+ connections.

Market share switch data center

Source: Arista Q4 2018 presentation

Thus, the competition will intensify for Nvidia. And from an operational perspective, medium-term synergies are limited.

From a financial perspective, management highlighted the accretive aspect of the deal for the non-GAAP gross margin and the non-GAAP EPS. As an illustration, the graph below shows the higher gross margins Mellanox generated over the last five years.

Chart Data by YCharts

But these accretive results don't say anything about shareholder value, which depends on the price of the acquisition.

A fair price

The $6.9 billion acquisition corresponds to a share price of $125. It represents a small 5.5% premium compared with the stock price before the deal was announced. But the stock price reflected the rumors of an acquisition.

Chart Data by YCharts

A $6.9 billion deal is important for Nvidia. As a comparison, revenue and income from operation amounted to $11.7 billion and $3.8 billion in 2018.NVidia fiscal 2019 revenue and net income

Source: 10-K fiscal 2019 Nvidia

And the transaction will consume most of the company's $7.4 billion of cash and marketable securities. NVidia net cash position

Source: 10-K fiscal 2019 Nvidia

Nvidia will still have a small positive net cash position after the deal.

I had argued in a previous article that, considering the growth prospects for Mellanox, a $6 billion offer was not generous.

Nvidia's offer at $6.9 billion represents an EV/TTM sales ratio at 6.34. From the historical valuation perspective, the offer seems fair considering the premium to pay to control the company.

Chart Data by YCharts

But the deal raises uncertainties around Nvidia. The lack of medium-term synergies and the increasing competition in the data center area bring extra challenges.

Management will have to realize the long-term integration of GPU and interconnection technologies to justify the growth associated with an EV/TTM sales ratio above 6x.

Conclusion

The acquisition of Mellanox by Nvidia ends the rumors and the speculations around such a transaction. Although the deal expands Nvidia's portfolio in the data center market, the medium-term synergies are limited. And the competition against dominant players like Cisco, Intel, and Arista will intensify.

The price for the acquisition is fair for both parties at an EV/TTM sales ratio above 6. But it increases the risks for Nvidia. The uncertainties around the execution of the long-term synergies between GPU and interconnection technologies are important.

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Disclosure: I am/we are long CSCO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.