Super Micro Computer: Sustainability In Question (NASDAQ:SMCI)

Introduction

After I first published my bullish call on Super Micro Computer, Inc. (NASDAQ:SMCI) in January 2024, the stock more than doubled within a few weeks, leading me to assume that this rally could not be sustainable – hence my downgrade in February. SMCI became the strongest stock in Q1 2024, so I included it in the review of the article “The Top 3 S&P 500 Stocks Of Q1 2024“, in which I confirmed my February assessment: SMCI’s business is growing fast, but I still had doubts that current margins could be sustainable.

Let’s take a look at whether this thesis is still relevant today.

SMCI’s Latest Financials And Developments

Just over a week ago, Super Micro published its results for the third fiscal quarter of 2024, beating the consensus forecast for earnings but falling slightly short regarding the revenue estimate.

With net sales soaring to $3.85 billion (+200% YoY and +5% QoQ), it’s evident that the company’s growth trajectory remains robust, but slows down on a QoQ basis.

I realize that demand for SMCI’s AI rack-scale DLC systems remains quite high – the company is a key partner for so to say “AI-enablers” such as NVIDIA (NVDA), Advanced Micro Devices (AMD), and Intel (INTC). However, it is also clear from Super Micro’s financial results that the company’s business model is struggling to overcome its peak in terms of gross margins. Yes, SMCI was able to keep its gross margin above 15% in 3Q 2024, but we don’t see a new peak, as in the case of NVDA:

The fact that SMCI has been able to significantly outperform the EPS consensus recently is due to optimal OPEX management: As COGS seem to grow in proportion to sales, SMCI’s management has been able to limit OPEX growth, resulting in a 281% year-on-year and 1.8 quarter-on-quarter increase in EBIT. However, the question is whether it is possible to increase margins even further. And I personally hesitate to answer this question, because in recent periods we have seen a kind of cyclical growth slowdown and quarterly margin contraction, not expansion.

I’m also confused by the discrepancy between the net income and the cash flow from operating activities.

Of course, there’s no mystery here: SMCI has been strategically building up inventory levels to meet increased demand, which according to the commentary on the earnings call suggests strong sales growth in the fourth fiscal quarter (i.e. the second calendar quarter). Also, with the upcoming launch of SMCI’s high-volume liquid cooling solutions, such as the more than 1,000 100-kilowatt liquid cooling racks scheduled to ship in Q4, the company has “ensured that it has sufficient inventory to fulfill these orders promptly and efficiently”. But nevertheless, as they scale up their operations, in my opinion, there’s a risk that working capital won’t reach a suboptimal level shortly and it will be difficult for SMCI to reach an FCFF adequate to its business size.

But if you do not take these issues into account – especially regarding margins – SMCI can hardly be described as a financially weak or poorly positioned company in its addressable market. Despite QoQ’s growth slowdown, on a YoY basis, Super Micro is experiencing accelerating revenue and particularly earnings growth as demand for its server and computing solutions expands rapidly. As the Argus Research team mentioned in its recently updated research report (proprietary source), SMCI has been growing earnings at a CAGR of around 53% in recent years, while the Tech industry earnings are growing at low double-digit percentages. Super Micro is at the forefront of the technology landscape, providing cutting-edge computing and server solutions tailored for the age of generative AI. According to Fact.MR’s research, over the next decade (by 2034), the global edge computing market is anticipated to surge from its 2024 valuation of $13.1 billion to a substantial $154.7 billion, reflecting a robust CAGR of 28% – the backdrop for SMCI’s future development prospects seems to be exceptionally good. And considering that Super Micro’s growth rate has been above the market average for many years, we can assume that the company’s growth rate may exceed the above-mentioned market growth rate in the coming years as well.

It’s necessary to say a few words about the updated FY2024 guidance, which has been raised to a range of $14.7-15.1 billion in terms of revenue, up from the previous range of $14.3-14.7 billion, indicating a strong demand trend extending into FY2025. For Q4 2024, SMCI expects revenue to be between $5.1 and 5.5 billion, implying an annualized revenue run rate of $20 to $22 billion. The non-GAAP net income per diluted share is expected to come at between $7.62 and $8.42 for Q4 and $23.29 and $24.09 for full-year 2024. As Goldman Sachs noted in its report (proprietary source), despite the record backlog in the third quarter, revenue growth continues to be hampered by shortages of key components, particularly components used in SMCI’s DLC racks. At the same time, we see SMCI’s implied gross profit margin at around 13.5% in all of the bank’s prediction scenarios – that’s 200 basis points less than in the third quarter:

Following the multiple upward revisions after the third quarter results, the market expects SMCI’s fiscal full-year 2024 revenue to be ~$30 million above the mid-range of management guidance and earnings per share to be 8 cents above the mid-range. The premium to guidance doesn’t look too rich, but it does indicate increased optimism – if SMCI has beaten guidance before, it should do so again. While I have no doubts about the secular growth prospects for SMCI’s business, I think it will be harder for the company to impress the market with anything as long as these Wall Street expectations persist. I’m puzzled by the fact that the 200 basis point loss in GP margin in just one quarter that GS writes about could scare off a lot of short-term thinking investors and force those who bought the stock in early 2024 to lock in profits if they haven’t already.

SMCI’s Valuation Update

Valuing Super Micro stock is a tricky business. On the one hand, we definitely see that current valuation multiples are well above their historical norms. For example, SMCI’s P/E ratio (~34.5x) and EV/EBITDA ratio (~29x) are 80% and 172% above their long-term averages, respectively, suggesting a huge overvaluation.

However, this view of SMCI valuation would be too one-sided: we need to consider that the current conditions for future (and current) business growth are fundamentally different from 3-5 years ago (not to mention longer time periods). We need to factor growth into our assessment, and one way to do this is to look at the PEG ratio, which, unlike the P/E ratio, indicates a significant undervaluation of the company (relative to the IT sector as a whole):

So what can we say about SMCI – is it overvalued or undervalued?

If we try to look a little into the future by focusing on the consensus estimates and giving them a small premium (e.g. 5%), then we can try to answer this question. However, the key assumption here is the “exit multiple” – I assume a continued decline in the multiple going forward as the industry cycle slows. At a 5% premium, EBITDA should increase by 54% year-on-year next year, based on YCharts data.

Taking the consensus as a basis and applying the same premium to EBITDA growth of 5%, the growth of this financial metric should slow to 16% in 2 years – this justifies the existence of my multiple contraction assumption.

I expect EV/EBITDA to fall to 15x by the end of next year – growth will slow (according to the current consensus) so the market will probably expect something like that and discount in advance. But 15x is still 41% higher than the long-term average of 10.6x, so the secular growth trend would still be priced in.

If my assumptions are correct, this gives an enterprise value of $38.6 billion, which after adjusting for net debt of negative $252 million gives an equity value of $38.84 billion, which is 19% below the current market cap.

My calculations may seem too pessimistic, but even my colleagues at Goldman Sachs are neutral and share some of my concerns.

We are Neutral-rated on SMCI with a 12-month target price of $800 (v. $937 prior) reflecting 23x NTM+1 EPS (29X prior). We lower our multiple on increasing uncertainty around SMCI’s AI server market share

Your Takeaway

So far Super Micro’s revenues have been growing much more rapidly than its OPEX, creating an environment for meaningful earnings growth – this fact if very hard to ignore. Super Micro market’s TAM is growing by leaps and bounds, while its presence in this market only appears to be becoming more stable. However, I also can’t ignore the fact that SMCI’s gross profit margin does not seem to have improved significantly. I think there’s a risk that SMCI may start missing EPS estimates in the coming years once the scope for cost improvements in operating expenses is exhausted.

At the same time, the company’s current valuation already raises questions – it seems that much of the future growth is already priced in, which cannot be said of the risks described in my article today. I believe that the sustainability of SMCI – both in terms of margins and the stock’s growth prospects – is currently in question.

I’d like to take another look at SMCI in the next quarter or when/if the stock price falls by 20-25%; until then I will not raise my rating to “Buy” from today’s “Hold”.

Good luck with your investments!