Starboard doubts Mellanox can meet 2018 targets

Eyal Waldman

The activist investor has slammed the Israeli big-data connectivity company's weak performance.

Starboard Value managing member Peter Feld has written to Israeli big data connectivity company Mellanox Technologies Ltd. (Nasdaq:MLNX) CEO Eyal Waldman with an abundance of data supporting Starboard's belief that the company has performed weakly and is not taking advantage of existing opportunities. Starboard also doubts that Mellanox can meet its 2018 targets.

Starboard became a party of interest in Mellanox two months ago with a 10.7% stake, making it the company's largest shareholder. The fund is known as an activist investor that seeks changes in the companies in which it invests including changes in management and on the board of directors. In its latest letter, Feld makes no specific demands. However, in contrast to previous struggles that Starboard had with Israeli companies, it has hired an Israeli media consulting firm - Eisenberg-Eliash - demonstrating that the struggle has moved up a notch and can be expected to be a protracted campaign.

"Tremendous respect for the business you have built"

Mellanox develops and markets equipment for transmitting big data swiftly and is traded on Nasdaq with a $3.3 billion market cap. The share price has risen 26.7% since Starboard invested in the company. Mellanox recently published its targets for 2018 including a return to double-digit revenue growth and an increase in operating profits.

In his letter Feld wrote, "We remain open to working with you to help drive significant improvements in operating and financial performance at Mellanox. Starboard has a long and successful history of working with companies in the semiconductor industry to drive significant value creation for the benefit of all shareholders. We believe there is a tremendous opportunity at Mellanox, but it will require substantial change, well beyond just the Company’s recently announced 2018 targets."

He stresses that there is already a dialogue between Starboard and Mellanox. "We have tremendous respect for the business that you have built. We invested in Mellanox because we believe the Company is deeply undervalued and there are significant opportunities to create value based on actions within the control of management and the Board."

"Unfortunately, despite an extremely strong product and technology portfolio, Mellanox has been one of the worst performing semiconductor companies for an extended period of time. As shown below, prior to our involvement, the Company dramatically underperformed the peer group and the broader semiconductor industry over the past 1, 3, and 5 years. In fact, in the 5 years prior to Starboard’s Schedule 13D filed with the Securities and Exchange Commission on November 20, 2017, disclosing our substantial ownership position, Mellanox underperformed the peer group and the Philadelphia Stock Exchange Semiconductor (SOX) Index by 470% and 300%, respectively.

"Since Starboard filed its Schedule 13D, Mellanox has outperformed its peers and the SOX index by almost 30%, which we believe is largely a reflection of investor enthusiasm for potential changes as a result of our involvement.

"This consistent underperformance is troubling and puzzling, given both the strong performance of Mellanox’s peers and the tailwinds provided by the Company’s favorable exposure to many of the most attractive end markets in the industry: high-performance computing, cloud computing, hyperscale data centers, and artificial intelligence. This underperformance has led to a crisis of confidence among investors and has contributed to Mellanox trading at a meaningful discount to its peers. We believe that this poor stock price performance has been driven by a pattern of weak execution that has included both excessive spending and missed growth opportunities.

"Looking at margins, Mellanox is one of the few fabless semiconductor companies that has been able to achieve gross margins in excess of 70%. Despite this enviable position, Mellanox has one of the lowest operating margins of any fabless semiconductor company of reasonable scale.

"In fact, the gap between gross margin and operating margin is among the highest we have ever seen for a semiconductor company. This is driven by what appears to be excessive spending in both R&D and SG&A. As detailed in the accompanying slides, over the last twelve months Mellanox’s R&D expenditures as a percentage of revenue were 42%, compared to the peer median of 22%. On SG&A, Mellanox spent 24% of revenue versus the peer median of 17%. It is critical to appreciate that Mellanox is not just slightly worse than peers on these key metrics, it is completely out of line with the peer group.

"Organic growth is lower than peers"

"While Mellanox’s level of R&D spending would be hard to justify under any circumstances, shareholders would expect that level of expense over a multi-year period to at least generate above-average revenue growth. However, as shown in the charts below, despite spending among the highest percentage of revenue on R&D in the peer group for a number of years now, Mellanox’s organic growth rate for 2017 will be the absolute worst of its direct peers. Even after accounting for the Company’s recently committed expectation of growth for 2018, Mellanox’s multi-year organic growth rate will remain at the low end of the peer group.

"We are also concerned that the targets outlined for 2018 are solely reliant on revenue growth to drive operating margin expansion, adding additional risk to the plan."

Feld adds data about missed targets in previous quarters and believes that, "How can shareholders have confidence that Mellanox will suddenly go from missing expectations to beating them?" he asks.

"Further, we are concerned that Mellanox has set the bar far too low. For example, even if the 2018 targets are achieved, Mellanox would still be expected to come in dead last among the peer group in terms of operating margins.

Published by Globes [online], Israel business news - www.globes-online.com - on January 8, 2018

© Copyright of Globes Publisher Itonut (1983) Ltd. 2018

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Eyal Waldman
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