Quick Thoughts: NVDA bets heavy on its datacenter ambitions

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Tejas Raut Dessai

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March 11, 2019

Quick Thoughts: NVDA bets heavy on its datacenter ambitions

  • NVDA’s deal for MLNX raises its growing exposure to hyperscale cloud datacenters, adding the leading high-speed networking chips to its dominant GPU franchise with the potential for considerable cost and strategic synergies.
  • NVDA and MLNX worked together on a supercomputing infrastructure for the US Dept. of Energy. Their complementary products will give NVDA greater influence on cloud architecture, enabling holistic solutions levering both processing and connectivity expertise.
  • Long term, the deal will be very beneficial to shareholders, diversifying NVDA revenue in another high-growth area and boosting margins. We believe it is positioned to be the dominant datacenter chip vendor for the AI/Cloud Era.
  • However, with the stock already up 7% on the announcement, we remain cautious for the near term as the company works down excess GPU channel inventory and copes with YoY sales compares bloated by those excess shipments. We expect a better entry point in the second half.

Finally, some happy headlines for Nvidia. The GPU giant will acquire Israeli hyperscale switching and interconnect chipmaker Mellanox for $125/share in an all cash deal, which drove MNLX up 8% and NVDA up 7% in Monday morning trading. The price paid is a 15% premium to Friday evening’s closing price and deal upon completion will be Nvidia’s biggest acquisition to date in its two decades plus history as a public company. Nvidia’s strength in supplying datacenters with GPU based acceleration hardware will now be further levered to supply high performance networking hardware gear, giving it a leg up in offering a broader AI-tuned hyperscale hardware portfolio. We have had both companies in our model portfolio at some point, removing MLNX for KEYS 18 months ago after suffering from wrenching volatility in what was then a thinly traded stock and then very recently moving to replace NVDA after holding it in for 30 months on the crypto misstep. Both moves served our model portfolio well but through repeated research we have maintained our liking for the companies and welcome the deal with great optimism (http://www.ssrllc.com/publication/the-tmt-model-portfolio-15-well-positioned-stocks-and-a-few-more/).

Mellanox, a pureplay for hyperscale networking gear and cloud SDN, supplies Infiband and Ethernet switching and interface chips which are staples in a high-performance and hyperscale computing environment. Mellanox’s hardware design basically allows implementation of two of the three basic functions of networking switch to be implemented entirely in code rather than chip level configurations, making it ideal for hyperscale datacenters that demand unpredictable adaptability and hands-off control over networking load management and switching. MLNX being the market leader in 25G+ high speed adapter market with over 65% of share globally, received windfalls from soaring hyperscale capex in the past 24 months.

Nvidia CEO envisions transforming the company into a modern era “server company”, offering hardware products serving all levels of the high-performance computing and hyperscale processing stack and networking gear is a natural extension of it. Both companies operate at the bleeding edge of supercomputing prowess and having control over end-to-end infrastructure that supports processing as well as networking can allow Nvidia to get one step closer to offering a complete AI optimized “processing platform” significantly eliminating bottlenecks occurred at interfacing, handling and packet delivery. Even Nvidia’s lucrative Gaming segment will eventually be migrated into the cloud with online gaming picking pace and most of the processing to be delivered remotely over the internet and in that sense Mellanox fits in well with all its business segments. Given the overlap in customers for both companies, we foresee significant synergies leading to cutting sales teams, forcing margin improvements and a renewed focus on R&D for specialized AI hardware.

The combined entity threatens Intel which is struggling to salvage its x86 dominance. Despite receiving windfalls from hyperscale capex, big cloud customers in recent times have shown an inclination for non-x86 architecture. As the CPU’s role diminishes from a processing element to a merely control element – which can be achieved equally efficiently through ARM or other less expensive architectures, it will be hard for Intel to differentiate. We can even anticipate Nvidia using its new leverage to offer a complete AI platform with commoditized CPU’s pre-installed, squeezing Intel into gradual obsolesce. Moreover, a flurry of news in the recent past of vulnerabilities detected (Meltdown, Spectre and more recently ‘Spoiler’ that allows attackers ability to view memory layout) in the hardware config of Intel chips do not help its case either (http://www.ssrllc.com/publication/quick-thoughts-security-concerns-demand-processor-diversity/).

Today’s gains are heartening but we expect Nvidia to trade sideways until it manages to completely put its crypto woes behind and compares become easier once again in 2H19. This deal will likely close during that timeframe as well. Chip companies have historically had poor visibility into end market demand and that combined with the lumpy nature of capex demand from hyperscalers, it is hard to tell which quarter will tip the scale exactly. However, the fundamental long-term narrative of the company remains the same and Mellanox acquisition is another move in what we believe is the winning direction.

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