At the start of the year, Super Micro Computer, Inc. (NASDAQ:SMCI) was the poster child of the AI craze, but the correction over the summer has taken the shares now down over 50% from their highs. This correction, and a solid fourth fiscal quarter, warrants an update on the shares here.
While top line sales results are largely fine, but will see a growth slowdown during 2025, the issue is that of a very soft margin performance, which feels unexpected and is weighing on the shares here.
Improving Server & Storage Solutions
Super Micro provides what it calls application-optimized and high-performance service and storage solutions, aiding in a broad range of computational and intensive workloads. The combination of hardware design, with an agile Building Block Solution platform, as well as in-house design and manufacturing gives the company a huge advantage: called speed to market.
These services are in great demand within the datacenter market, not just for actual performance of tasks, but also for economic and ESG reasons. Greater design allows for higher efficiency (through a lower PUE ratio), which is desperately needed given the availability (or lack thereof) of power as well. Moreover, the integrated set of solutions and entrepreneurial spirit have allowed the company to reap the benefits of this craze.
It has not always been like this, as Super Micro has long been a publicly traded business which has seen solid, but not outrageous growth. With the fiscal year ending in the summer, the company started to see accelerating growth recently. 2022 sales rose by 46% to $5.2 billion, with revenues up another 37% in 2023 to $7.1 billion.
With gross margins in the high-teens, amidst a high bill of materials, the company reported operating margins around 10% of sales, allowing GAAP earnings to double towards $11 and change per share.
Accelerating Momentum
The company originally guided for fiscal 2024 sales to rise towards $10 billion. First quarter sales were reported at $2.1 billion, second quarter results were reported at $3.6 billion, with third quarter results reported at $3.8 billion and change. At the start of the year, the company guided for fourth quarter sales around $5.3 billion.
The company did not take advantage of its customers given the market situations, posting operating margins similar to the past, and not jacking up prices to benefit from the lack of supply. This came with a drawback, as the company was forced to fund huge working capital requirements with the issuance of shares and notes. In general, these were well-timed in the first quarter.
With earnings power trending around $25 per share, an $800 stock in May commanded a premium. It was not so much the valuation multiple which posed the biggest risk, but rather the sustainability of demand, sales and earnings, at least in my view.
With earnings power even trending at $32 per share based on the fourth quarter outlook, multiples seemed more reasonable, yet a normalization in earnings could make that earnings might fall to single digits, being the biggest risk in my view.
Margin Shortfall
Early in August, the company reported its much awaited fourth quarter results, with revenues reported at $5.31 billion, up 143% on the year before, in line with the original guidance. That was about the good news as margins actually took a beating, with gross margins reported at 11% and change, comparing to margins around 14% and change for the year.
GAAP operating margins came in at just 6% and change, for GAAP earnings of $5.51 per share, as non-GAAP earnings of $6.25 per share missed the $8 per share guidance by a wide margin. Moreover, cash flows used from operations totaled over $600 million, as inventory levels rose further to $4.4 billion.
Fortunately, the balance sheet remains in a solid position. A half a billion net debt load (which includes $1.7 billion in convertible notes) is manageable. Assuming non-conversion, the company has 59 million shares outstanding.
Trading at $535 in overnight trading, valuations have come down a long way, as $25 in earnings power yields a 21 times earnings multiple, largely at par to the market, while spectacular growth is still being reported.
The Outlook
The problem for the shares is with the outlook, not just the first quarter outlook for 2025, but really the outlook for the upcoming year. This is despite potential optimism around potential demand for cooling and liquid solutions to increase efficiency for its end customers.
For the first quarter, the company sees continued solid growth (both sequentially and annually) with sales seen between $6 and $7 billion. This outlook is rather wide, which tells you the degree of uncertainty, with non-GAAP earnings seen between $6.69 and $8.27 per share.
The latter suggests no near term spectacular margin recovery, which the company attributes to competition, availability of components and new capacity being brought online, as well as new liquid cooling techniques.
Moreover, the full-year outlook is not too convincing, with full-year sales seen between $26 and $30 billion. At the midpoint of the range, this suggests a midpoint of $7 billion in sales per quarter, which suggests that sequential revenue growth will essentially flatten out in the coming quarters.
Moreover, on the conference call the company admitted that new component shortages hurt fourth quarter sales by around $800 million, which are to be recognized in the first quarter of 2025. That really implies that if component would be available, a $6.1 billion revenue number should be attainable in the fourth quarter of 2024. This reveals that without these extra sales, revenues are seen at $5.2-$6.2 billion for first quarter sales, which would imply sequential revenue declines.
What Now?
While management aims to ignite some enthusiasm in the shares, with the announcement of a 10-for-1 stock split, investors are focusing on the cooling operating performance, with no (spectacular) growth seen from here anymore. Worse is the unexpected shortfall in margins, as realistic earnings likely are stuck around $25 per share per annum here.
On the other hand, margins are already normalizing, and even with lower margins, shares only trade at a 21 times earnings multiple. While some net debt has been taken on, this is manageable. I see no need for more equity issuances (at lower levels here) to finance (inventory) growth, as overall growth is set to slow down quite a bit, with operating cash flow generation likely seen this year.
Amidst all this, the Super Micro Computer, Inc. performance is a bit softer, but the overall appeal is increasing rapidly. Even if operating margins are stuck around 5% of sales and the company might see sales come down to about $15 billion, a $750 million operating profit number could easily yield a double-digit earnings per share number in such an extreme scenario. If earnings were to fall back to such levels, this would result in a demanding valuation at nearly 50 times earnings.
Hence, I am happy to buy into the shares on dips here, looking for some kind of re-rating, as it is evident that the greatest craze is now a thing of the past already.
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