For Whom Is Mellanox Creating Value? Not You

Most of the value Mellanox created over the past year went to top employees with stock options. Other shareholders are less fortunate.

Some readers may think I’m obsessed with Mellanox Technologies and its finances. I don’t mind. When something bad happens to investors and other people get rich by exploiting bewilderment by investors and analysts, it’s only right to talk about it and hold it up to scrutiny again and again.

Mellanox recently published its results for the fourth quarter of 2012 and for the year. As always, the debate in the press was about whether the company met forecasts, whether it would lower its guidance to investors and the wild swings in share price before and after the report.

Long-time readers already know my opinion about this never-ending quarterly farce of which Wall Street and the financial media are so fond. It is a foolish custom worthy of day-traders who bet on swings in share prices.

A real investor doesn't invest in shares that “beat the forecasts.” Rather, he wants to be a long-time partner in the business that stands behind those shares and enjoy his fair share of the company’s future profits.

So this time, my discussion will not deal with what Mellanox did during the fourth quarter or with its predictions. I will leave that to others, who will be thrilled to do so.

My discussion is how much internal value Mellanox created for its shareholders in 2012. Those who read the company’s financial report, as the company presented, will say they created “about $156 million.” That is the number that the company published as its net profit, though that's after adjustment - not based on GAAP ("generally accepted accounting principles").

My answer to the question of how much internal value Mellanox created for its shareholders in 2012 is very different. According to my calculations, which I will present in just a moment, the answer is “about zero,” and perhaps even negative value.

Of course, a disparity like this needs explanation. Leaving aside the predictions and disappointments, or surprises and share price fluctuations, everyone agrees that Mellanox Technologies is profitable – its income, after all, is greater than its expenditure.

So why do I say it created zero internal value? A company that created profit that gets translated into positive cash flow should, at the end of a given period, be worth more than at the start of the period. The difference is the internal value that it created. So where’s the problem?

As in other companies too, the problem with Mellanox isn't cash flow, it's change in share capital. It lies in change in the number of shares throughout the year, and the money paid for them. Analysis of these numbers reveals a completely different picture.

Sleight of hand

Here are the numbers: The average number of Mellanox shares in the fourth quarter of 2011 was approximately 39.5 million.

In the last quarter of 2012, the number was approximately 42.5 million.

The increase over those 12 months stems from the exercise of stock options by employees, senior managers and members of the board of directors.

This is a dilution of 7.5 percent that stems from the issuance of about three million shares. These are rough numbers but precision has no meaning at the level of a single share. What’s important here is the principle.

The shares held by a Mellanox Technologies shareholder over the year were therefore diluted by 7.5 percent during that time.

Dilution is not the end of the world. The important question is what the shareholder received in exchange for it.

If he received appropriate compensation in return for diminishment of his holdings, which means a decrease in his fair share of the company’s future profits, then there is no problem.

How much compensation did long-time shareholders received for being diluted? it is easy to see. That would be the amount of cash that went into the company’s coffers as a result of issuing the shares.

A glance at the cash-flow report shows that the company received about $30 million from issuing shares in 2012, which comes out to about $10 per share. The controlling owners’ sales reports also show that many of the options were exercised at prices like $9 and $10 per share.

Now let's calculate the shareholders’ loss. It’s not all that complicated.

Let’s say that instead of the recipients getting the three million shares as options at $10 each and selling them on the market at an average price of $80 per share, Mellanox itself did so. In other words, let’s say Mellanox Technologies sold three million shares on the market at an average price of $80 per share.

As far as dilution goes, the result for the shareholders would be the same. The rate of their holdings in the company would decline by about 7.5 percent, but the compensation for that dilution would be much greater.

In reality, the compensation for the dilution was about $30 million, which went into the company’s treasury. In the second theoretical case, the compensation would be $240 million, which would have gone into the company's bank account.

The gap between the two amounts, about $210 million, is the loss suffered by the tolerant shareholders who simply want to be partners in Mellanox’s transactions.

Now, if the company would have made $210 million more from selling shares on the market, it would have paid higher tax, but not much higher; the upshot is that practically the entire profit for the year went to a few hands in a clever way that was not spelled out in the financial report. Also, it was ignored even by investors and analysts and the press, whether because they didn't see it, didn't grasp it or because when a stock is red-hot, nobody wants to deal with minutiaea such as where the company’s profit is really going.

Looking the other way

This raises another point as well. If this kind of maneuver, in which a great deal of wealth passed from the investors to a small group of managers, interested parties or senior employees, were to happen in a firm that is not a technology company and in a less complicated way, the entire capital market and the financial media would scream bloody murder, and with good reason.

Transactions by interested parties that harm investors, haircuts and unreasonably high salaries all get lashed in the press. Such things also require a thousand permits of various and sundry kinds, which is as it should be. Otherwise, managers and owners would do as they pleased with the companies they ran, to the detriment of investors and creditors alike.

But for some reason, when things like this happen in successful technology companies, public interest and criticism are forgotten. Maybe it’s because of the clever way it happens or because of the dream these companies embody. Maybe it’s because such large profits for the interested parties are usually created while the stock is soaring to the skies. At a time like that, nobody cares what is really happening inside the company or how much it is really making for its shareholders.

All I can do is urge investors - before you buy shares in brilliant technology companies - study the data carefully. Study the numbers and the future dilution potential and see how much potential wealth can pass from the many to the few.

Often, this sort of analysis is every bit as important as an analysis of the company’s technological capabilities.

The writer is an independent financial consultant. This article is not intended as a recommendation to sell or buy shares or as investment advice of any kind.

Reuters