Nvidia: Mellanox Deal Is Welcomed

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About: NVIDIA Corporation (NVDA), Includes: MLNX
by: The Value Investor
Summary

Nvidia has emerged as the winner in the bidding war for Mellanox.

Despite the big premium being offered, investors seem to agree that Nvidia has made a very compelling deal here.

I understand the rationale behind the deal and agree, yet am in no rush to chase shares higher from here.

Nvidia (NVDA) announced both an interesting as well as sizeable acquisition as it has reached a deal to acquire Mellanox (MLNX) in a rather large $6.9 billion deal. This deal is really driven by a strategic rationale, that of offering competitive computing power in combination with speed in the key data center market, as investors seem to understand and embrace the deal, despite the apparent bidding war for Mellanox.

I appreciate the rationale behind the deal as well, yet find myself in no rush to chase the momentum run we have seen over the past six weeks, following the very soft Q4 results. While I really believe that Nvidia has a long-term promise and bright future, I am in no rush to chase shares here.

Deal & Rationale

Nvidia has reached an agreement to buy out Mellanox in a deal which values shares of the company at $125 each, marking an enterprise valuation of $6.9 billion

The deal is driven by combining leading companies in high performance computing, more specifically combining Nvidia's computing platform with the interconnect power of Mellanox.

The increase in data and compute intensity, driven by AI and data analytics (among others), is resulting in exponential growth in data and traffic, pressuring both hyper scale and enterprise data centers. With Moore's law ending for CPU performance advances, the market is shifting towards accelerated computing with the usage of Nvidia's GPUs as well as expertise of Mellanox in networking solutions.

Thus, the architecture of data centers becomes ever more important, and this is the strength of Mellanox, creating optimal solutions for customers of the combination. This is important as the global data center market is $60 billion large and growing rapidly.

The deal is largely driven by strategic reasons as the solid financial state of Nvidia means that financing will not be an issue. No specific synergies have been identified (just yet) as the deal is clearly driven by offering superior offerings to customers.

Pro-Forma Implications

It must be said that the premium offered for Mellanox does not look that steep, with shares having traded around $110 per share in recent days ahead of the $125 deal tag. This is not really fair as rumours about a deal surfaced late January with Intel (NASDAQ:INTC) reportedly having offered $6 billion for the firm. This came after Microsoft (NASDAQ:MSFT) was reportedly interested late in 2018, with shares trading in the low-eighties at the time. Adjusted for that, the realistic premium comes in around 50%, suggesting a realistic dollar premium close to $2.0-$2.5 billion has been paid.

The $6.9 billion valuation does not come so cheap as Mellanox generated $1.09 billion in sales in 2018, for a 6.4 times sales multiple, although sales grew by 26% last year. The company has posted GAAP operating earnings of $112 million, for margins at just around 10%, as R&D takes a pretty heavy toll on the bottom line, equal to a third of sales.

Despite the big premium offered, investors in Nvidia were very much upbeat on the deal as its shares rose $10 per share, or by $6.2 billion in actual dollar terms. Despite the premium paid for Mellanox, shares of Nvidia rose by almost the same in absolute value terms as the valuation of the company which it has just bought! In terms of sales multiples, the deal makes sense as Mellanox is bought a little over 6 times sales, while Nvidia trades around 8 times sales, with revenues seen down slightly in the fiscal year 2020 (roughly calendar year 2019). This is contrary to a more steady growth trajectory of Mellanox, although that business is relatively less profitable of course.

For the overall business, the deal has some implications as well. Pro-forma sales of $11.7 billion in 2018 will increase by roughly 10% in the year to come. In terms of earnings contribution, the picture might be more balanced. The good news is that Nvidia ended Q4 with net cash balances of $5.4 billion, allowing it to fund most of the deal with own means. With net interest income currently trending at roughly $100 million a year, this income will be forfeited and some modest net debt will be taken on. The net impact of this is roughly equal to the operating income to be contributed by Mellanox.

With the implications for earnings per share being flattish to slightly positive in the near term, it is clear that investors like the strategic nature of the deal. With the modest net debt load of $1.5 billion pro-forma, the deal is really very modest by all means given the enormous earnings power of the business, let alone the combination, as well as further growth opportunities.

Concluding Remarks

Late January, I looked at Nvidia as the company reported outright terrible fourth-quarter results. Those results furthermore indicated that weakness was not just limited to the crypto craze, but was seen in other regions as well as swift recovery was not expected.

I was kind of shocked by the amount of the shortfall in sales as I have lowered my potential entry target from $135 to $125 at the time, not having held a position as a consequence. Unfortunately, shares had only fallen to $130 in the days following the release of those results as I have not held a position in what has been an impressive 25% rally ever since to levels in the $160s and change. That being said, one has to recognise that the overall market has seen a very nice run as well of course.

For now, I see no reasons to chase the momentum, although I very much look forward to what the new combination can bring in terms of improved growth profile and more diversity into the long-term promise which Nvidia still very much is.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.