Super Micro Computer: Siding With The Bulls, But Risks Remain (NASDAQ:SMCI)

Thesis

Super Micro Computer (NASDAQ:SMCI) has seen a large amount of operational success, but this success comes with skepticism from investors. The bulls point to stunning revenue and earnings growth, a differentiated business model, and an attractive valuation. The bears point to challenges generating operating cash flow and customer concentration risks. We believe that this is a difficult one to value. While we side with the bulls, investors should study this company to determine their own thoughts.

Bull Argument

Super Micro has been executing well operationally and financially. In their most recent quarter they reported 54% year over year revenue growth and 270% year over year growth in non-GAAP EPS. The rapid pace of these increases seems almost too good to be true, and some bears argue they are.

Super Micro has done well to differentiate their business model and has chosen to focus on “green computing”. Green computing is really just an ESG way of saying power efficient. Companies that purchase Super Micro’s solutions have total cost of ownership in mind, which is much more important than the upfront cost of purchasing racks, CPUs/GPUs/ASICs, etc. As energy costs have increased, purchasers of racks have begun to focus more on efficiency than they may have in the past (although energy savings have always been a priority).

It makes sense that Super Micro’s organizational focus on energy efficient solutions is benefiting them. This differentiation gives them a competitive advantage over their peers. This is important because many of Super Micro’s peers have a scale advantage, so for Super Micro to remain competitive they must continue to meaningfully differentiate themselves.

When a company sees such a rapid increase in revenue and net income it naturally attracts a lot of attention to the stock. Such a situation is like honey and as such will attract a few bears.

Bear Argument

Spruce Point Capital Management published a short report detailing some of their issues with the company. We will go over a few of their main points and our thoughts on these arguments. All quotes are taken verbatim from the short report.

Spruce Point thought that the days of revenue growth at all cost for technology companies were over, and cash flow finally mattered. However, investors appear to be buying into the CEO’s aggressive, if not outlandish and wildly optimistic revenue targets, even if they include related-party revenues and come from a Company with a troubling history known to aggressively push employees to record revenues without proper accounting controls. The CEO is already claiming revenue targets of $8 – $10 billion for 2024 while touting it will soon be a $20 billion revenue company. However, we caution that Super Micro’s business has, at best, quarterly revenue visibility and it does not even report a backlog figure.

Spruce Point is likening Super Micro to a technology company, when in reality it is more akin to a manufacturing company. As a manufacturing company that has to inventory physical goods it is naturally going to experience negative cash flows during a growth cycle. This is unlike tech companies which do not have such high working capital and inventory requirements, and whose cash conversion cycles are much shorter. The comparison between Super Micro and the broad category of “technology companies” is flawed.

Spruce Point is conflating low amounts of operating cash flow generation during a growth cycle with “growth at all cost”.

Their comment about poor revenue visibility may have some truth to it, as Super Micro has given guidance for revenue growth of 25% to 44% for fiscal year 2023. This is a pretty wide range of potential outcomes, which is surprising given how far they are into their fiscal year already.

Once investors get past the revenue story and focus on cash flow, we believe it will be illusive and unlikely to materialize. SMCI’s history shows that its cash flows are irregular and lumpy, so we evaluate it over a long-term horizon. Based on our analysis, over the past 7yrs+ we find that it has reported cumulative revenues of $27.4bn, GAAP Net Income of $1.0bn,$164m of Adj. Cash from Operations (CFO) and Adj. Free Cash Flow (FCF) of -$142m. We caution investors not to put undue reliance on SMCI’s GAAP (or aggressively presented Non-GAAP) net income given a conversion rate of just 16%.

Bulls would argue that Super Micro is a company that has materially changed from how they were in the past, and that they are currently in a growth cycle. Spruce Point has brought up a valid criticism of the company here, but the business landscape changes a lot over a seven year period. Sticking to the tech hardware space, AMD almost went bankrupt but is now a massive company with healthy operations. Super Micro may indeed be a new company now, which makes comparisons to the past less relevant.

SMCI appears to now be targeting larger customers, which carries with it greater risks such as bigger discounts and margin concessions along with worsening payment terms. In fact, we find that SMCI’s working capital has intensified and its debt dependency to fund cash flow deficits has been increasing. It provides metrics on conference calls such as cash conversion cycle, days inventory, sales and payables. However, SMCI doesn’t provide these metrics in SEC filings or give a definition to check its calculation. Based on an industry accepted measure, we find its cash conversion has been worsening in the past few years and is well above management’s “target” of 85-90 days.

With a cash conversion cycle of 95 days, the cash flow situation is certainly less than ideal. Hopefully this will improve over time and give the company more financial flexibility. A focus on targeting larger customers also comes with advantages that Spruce Point conveniently omitted. These include increased visibility into future order volume and larger order sizes. There is also something to be said about the increased operational simplicity that comes with having less customers.

SMCI began disclosing a rise in customer concentration in early 2022, but without disclosing who has been driving its recent performance. In the most recent quarter, 21.9% of revenues were from this lone customer. Based on our research, we find that the largest customer is Facebook / Meta Platforms. Facebook itself has been struggling and publicly announced cost reduction measures. Our research indicates that SMCI’s business with Facebook is susceptible to spending reductions, along with overall technology hardware spending for cloud computing and datacenter markets. In fact, DIGITIMES recently reported that Facebook suspended construction of two datacenters in Europe and rescheduled the establishment of two similar facilities in the U.S. It also reported on a contraction of growth in the server market. Furthermore, recent research from Morgan Stanley (ASIA) indicates that Facebook’s cloud spending volumes are down 5-10% year- over-year with a competitor. These factors present growing risks to SMCI achieving its financial targets.

While Facebook’s short-term datacenter spending may decrease, this isn’t what drives the intrinsic value of Super Micro. The value of the business is determined by long-term order volume. Customer concentration will change from time to time as companies enter and exit investment cycles at different times. What is important is total volume over the length of the cycle. This obsession with Facebook and their near term operational challenges seems shortsighted.

Spruce Point was also concerned about the potential for another financial reporting scandal. While this could very well happen, for the time being it is purely speculation. It is difficult for investors to estimate the likelihood of fraud and thus equally difficult to estimate the financial consequences of that hypothetical fraud.

Price Action

Super Micro has been on a tear over the past year, and SMCI stock’s performance looks good over a five year period as well.

Valuation

By traditional fundamental metrics Super Micro appears to be very attractively valued. This is a major reason why many bulls like the stock, the valuation seems to be outrageously low for a company that is growing as fast as they are.

Of course, the bears will point to the price to free cash flow and state that the company has some work to do on the cash flow generation front.

If Super Micro is able to improve their operating cash flow generation the company is likely undervalued at these levels.

Risks

Since this is a neutral thesis, let’s take a look at some upside and downside risks for the stock.

Upside Risks

Super Micro is able to dramatically improve their free cash flow generation.

Their differentiation strategy continues to result in high levels of revenue and earnings growth.

Customer concentration doesn’t end up adversely impacting Super Micro.

Downside Risks

Super Micro sees a drastic slowdown in order volume and is stuck with a large amount of inventory.

Super Micro ends up having another material financial reporting scandal.

The company is unable to improve their cash conversion cycle and is unable to improve their operating cash flow generation.

We side with the bulls here but the risks are very real and investors should take a deep dive into this company before investing.

Key Takeaway

The bulls point to stunning revenue and earnings growth, a differentiated business model, and an attractive valuation. The bears point to challenges generating operating cash flow and customer concentration risks. We believe that this is a difficult one to value. While we side with the bulls, investors should study this company to determine their own thoughts. If the company improves their operating cash flow generation it is likely undervalued at current prices, potentially by a large margin.