Description

SMCI- Long Thesis

Super Micro Computer (SMCI) is a leading seller of server devices and represents an under-the-radar transformational value security whose story has yet to be appreciated by the market.  Over the last few years, the Company has been tarred by two exogenous factors irrelevant to its business fundamentals that masked the significant progress the Company has made in bringing to market its differentiated core server product devices.

From the middle of 2017 through the end of 2019, SMCI faced an accounting issue overhang which precluded the Company from filing its fiscal 2017-2019 (ending June) financials and ultimately forced SMCI to delist from the NASDAQ and trade on the pink sheets OTC exchange.  The accounting issue turned out to be completely immaterial, but a broad range of institutional investors unable to hold “non-current” stocks were forced to sell their shares, and many others were unable to invest in a delisted company.  Second, in October 2018, just as the Company was beginning to make real progress on restating its financials, Bloomberg News published an article accusing SMCI of being a link to a Chinese hack of US intelligence, sending the stock into an immediate downward spiral to as low as $12.40 in a matter of days.  Over the ensuing weeks the article was refuted, but the overhang lingered and some customers temporarily delayed purchases impacting SMCI in the short-term.

Now, over a year and a half later, the Company is up to date with all its financials and has been relisted on the NASDAQ.  Moreover, the negative article has been completely refuted, but still the market has only just begun to realize the underlying earnings power of SMCI.  While all this noise has swirled, the Company has created a unique and tailored server product enabling superior growth, while simultaneously exhibiting strong, sustainable operating margins and generating significant free cash flow.  Reflecting these factors, we estimate the Company will earn $3.40 of EPS in fiscal 2021, a significant improvement from its historical earnings power.  Applying a 15.0x P/E multiple, in-line with its historical range and reflective of its growth potential, we believe the stock is worth $51.02 per share or 68% upside to the current stock price.  Thus, we view SMCI as a compelling investment at these levels.

We believe the following catalysts should help unlock the material value embedded within SMCI: 1) solid overall top line growth for server demand going forward, driven by ongoing hyper-scale data consumption, enabling investors to view the industry in a more favorable manner; 2) SMCI to outgrow the industry, achieving a low-double-digit CAGR by gaining share through its unique and tailored product offering, augmented by the new Intel chip refresh cycle; 3) continued strong gross margins resulting from a favorable memory pricing curve; and 4) the upcoming Analyst Day to highlight long-term growth targets and illustrate an estimated $5.93 of long-term EPS power, as well as potential for share repurchases driven by robust free cash flow generation and $4.79 of current cash per share.

Firm Structural Demand for the Server Market

A server is a mostly hardware component that provides functions for other clients or programs to run in a shared and efficient manner.  Super Micro Computer builds these servers for use by a range of end users including enterprises, data centers, and smaller businesses.  Its growing market share stands at an estimated 3.7% currently, and SMCI competes principally with two main other players - Dell (DELL) and Hewlett Packard Enterprise (HPE) with approximately 16.0% market share each.  Up until 2007, the server market grew consistently with computing power, eventually hitting $55 billion in sales.  Then it entered a ten-year plateau as the industry faced the virtualization headwind, a movement away from individualized server usage towards a more shared architecture.  Only in the last three years has the server market re-entered a growth phase as the hyperscale datacenter infrastructure trend has begun to offset virtualization.  We believe that investors have not fully appreciated the sustainability of this new era of server growth and are still valuing SMCI as a flat grower deserving of only a low valuation multiple.  Massive internet usage and cloud computing is revamping the entire technological and informational landscape, driving gigabyte usage by an estimated 25% per annum, and in turn requiring leading datacenter providers like Facebook (FB) and Amazon (AMZN) to add server capacity in large quantities for the foreseeable future.  This has created a new paradigm for the server market and transformed ten flat years into an average of approximately 17% annual growth over the last three years.  With no end in sight for hyperscale computing growth, SMCI is poised to benefit from this investment theme refresh.  Based on our analysis, we believe the server industry, although likely to moderate from its recent above-normal growth rate, will continue to grow in the mid-single-digit range for the next several years.

SMCI Sales Growth to Outpace the Broader Market

SMCI presents an ideal way to capitalize on server market growth because it has meaningfully outperformed the overall market.  Under the leadership of CEO and founder Charles Liang, the Company has spent $1.1 billion in R&D over the last ten years and built out the capacity to provide its buyers customizable solutions at volume-priced economics, something that none of its competitors can replicate.  Whereas HPE and DELL outsource the design of the hardware to Taiwanese original design manufacturers ("ODMs") like Wistron (3231 TT) and Quanta (2382 TT), SMCI uniquely owns the design and the marketing of its server hardware.  We believe the market is completely overlooking just how much SMCI has differentiated itself from its more commoditized peers.  Server hardware design consists of server motherboards, chassis design and power supply, but most importantly, it requires interchangeability of these components to enable flexible and efficient usage of the latest compute, DRAM and storage resources, which vary based on specific end application needs.  On the other hand, for over 20 years now, Dell and HPE have outsourced the design of their hardware to the Taiwanese ODMs, and in doing so have effectively given up their ability to customize products according to emerging customer needs.  They are personified as "box" companies, selling high volume and low tech solutions.  Our checks indicate that SMCI offers around 400 SKUs versus only a couple of dozen offered by HPE and Dell.  This is all especially relevant these days as customers proactively seek to manage enormous and complex data loads.  This, in our opinion, is why SMCI has been able to grow its market share tenfold in the last 15 years.  Our analysis suggests that SMCI has outgrown the industry by an estimated 600 basis points over the last several years, and we expect this trend to continue into the future.  Therefore, as the server market grows 4-5% per year, we estimate SMCI can readily achieve a base case top line CAGR of 10-11%.

The SMCI story, however, is at a further inflection point, which should enable growth even beyond that base case.  One of the leading demand drivers for server purchases revolves around the embedded processor, as customers will decide to order new server hardware to coincide with a processor refresh.  We approximate that over 80% of SMCI's servers are embedded with an Intel (INTC) chip.  Over the next several quarters, Intel is rolling out not only a slimmer reduction in nanometer architecture known as Skylake, but also a 30% faster capability known as Cascade, marking a unique moment in processor demand for not one, but two reasons for customers to upgrade their servers.  Because SMCI’s typical customer is looking for a more value-added approach, refresh cycles tend to benefit SMCI disproportionately from its peers.  Analyzing prior refresh upticks, we estimate this will add 250 basis points of annual growth to SMCI in the near-term.  Lastly, there is another factor that will augment SMCI's growth in the near- to medium-term.  Advanced Micro Devices (AMD), which has been less impactful to the market, is now forging a comeback to compete with Intel through the introduction of its Roam product, which provides a cheaper and smaller 7-nanometer footprint versus Intel's 14-nanometer.  Our checks indicate that Dell and HPE servers do not really work well with AMD, and thus this should provide SMCI a singular advantage.

Every point of market share gain or growth beyond the overall market equates to $0.08 of EPS, or $1.15 per share of value based on our 15.0x P/E multiple.  Accordingly, our estimate for 850 basis points of SMCI-specific growth equates to $0.65 of EPS, or $9.76 in value per share, representing additional upside of 32% to the current share price.

Favorable Memory Dynamic in Place for Strong Gross Margins

We believe the market does not fully understand SMCI’s trajectory of favorable and sustainable gross margin improvements going forward.  Since the Company's operating expenditures of approximately $370 million this year should continue to be managed in a very disciplined manner, gross margin is the most critical determinant of profitability.  The biggest swing factor to SMCI’s gross profit is the cost of DRAM and NAND memory inputs necessary to building the server.  Starting in fiscal 2015, SMCI's full-year gross margins began trending down from 16.1% to as low as 12.9% in fiscal 2018, with each 100-basis point move equating to a sizable $0.52 in EPS.  Because of this prior trend, the market has understandably discounted the earnings power of SMCI as it perceives the margins as pressured and unpredictable.  However, a closer look at factors affecting memory pricing over the last few years and those currently in place, tell a very different story.  Beginning in 2014, semiconductor manufacturers raced to produce memory in order to meet incredible hyperscale and data center growth, alongside a surge in smartphone storage capacity demand.  They needed to adapt to this new norm and found themselves short of the necessary supply and challenged by low manufacturing yields necessary to manage spikes in memory demand.  This, in turn, caused memory pricing to go up nominally and spike frequently, causing buyers like SMCI to ineffectively pass on these surges in pricing to their customers, thus harming SMCI’s margins.

We believe even bullish sell-side analysts are overlooking the impact of memory pricing on SMCI’s gross margins.  Based on our channel checks, the single most pivotal factor affecting the Company's management of gross margins is the "slope of change" in the memory curve (and less so the actual price of memory).  Over the last few years, as semi-chip makers have adapted by improving their yields and built out more baseline capacity to meet growing demand, and as smartphone growth has plateaued, the pricing spike issues have begun to abate.  Therefore, we believe memory buyers like SMCI will benefit from “calmer” and more sustainable margins going forward.  In fact, over the past several quarters we have already seen a paradigmatic shift in gross margin variance in the 16.0%-17.5% range, neatly supporting our 16.5% estimate in 2021.

Analyst Day To Signal a New Chapter in Shareholder Alignment

In addition to the fundamental business transformation, we believe the Company is on a new strategic path.  Despite being immaterial, the accounting issues and subsequent audit had clearly thrust SMCI into a new chapter of financial and shareholder discipline.  The audit prompted the promotion of Kevin Bauer to CFO in January 2018, who expeditiously oversaw the financial refiling process in a smooth and well-communicated fashion.  But Bauer went beyond, helping to make transformational changes in cash collection and free cash flow generation, as well as in setting guidance for the Street.  In fact, under his leadership the Company has beaten eight of the last nine quarter guides.

SMCI is now planning to hold its first ever Analyst Day in August 2020, a remarkable milestone for a company with such a cloudy past.  We believe this event will serve to communicate two critical shareholder issues.  First, SMCI will lay out a three- to five-year revenue and EPS target trajectory.  This should help mitigate investors’ backward-looking concerns around extreme cyclicality, and help to instill confidence in the long-term secular thesis fueling SMCI’s much larger sales growth and EPS power.  We expect the Company to reinforce its ability to grow meaningfully higher than the industry’s mid-single-digit growth rate, by delineating the forces behind its market share gains.  We also expect a detailed analysis around sustaining strong gross margins and leveraging its scalable operating expenses. For a value stock that not long ago traded on the pink sheets, to now carve out a path to an estimated $5.93 of EPS, should result in a material revaluation upward. 

Second, as stated, Kevin Bauer has turned SMCI into a free cash flow generating machine.  Since he has taken over, the Company has generated $324 million of cash, or 21% of its current market capitalization.  We estimate the Company can generate $173 million of free cash flow through the end of fiscal 2021.  This will bolster its already impressive net cash position of $268 million or $4.79 per share.  With the external challenges behind them and a favorable path forward, we believe the Company is now finally confident enough to return cash to shareholders in a potentially dramatic fashion, similar to the actions of our portfolio company Herbalife Nutrition (HLF).  The Analyst Day should serve as the perfect opportunity to lay out a potential share repurchase program, and help to further unlock the value within SMCI.

Conclusion

In summary, SMCI is an under-the-radar value stock undergoing a transformation that has yet to be appreciated by the market because of its murky past.  We feel confident in the management team’s ability to execute going forward and achieve stellar top line growth and profitability.  We estimate $3.40 of earnings per share in 2021, and apply a P/E multiple of 15.0x, resulting in our $51.02 price target, or 68% upside to today’s share price.

Any forward-looking opinions, assumptions, assessments, or similar statements constitute only subjective views. This information should not be relied on for investment decisions and is subject to change due many factors, including fluctuating market conditions and economic factors.  Such Statements involve inherent risks, many of which cannot be predicted or quantified and are beyond our control. Future evidence and actual results could differ materially from those set forth in, contemplated by, or underlying these Statements, which are subject to change without notice.  In light of the foregoing, there can be no assurance and no representation is given that these Statements are now, or will prove to be, accurate or complete. We undertake no responsibility or obligation to revise or update such Statements.

Catalyst

1) solid overall top line growth for server demand going forward, driven by ongoing hyper-scale data consumption, enabling investors to view the industry in a more favorable manner;

2) SMCI to outgrow the industry, achieving a low-double-digit CAGR by gaining share through its unique and tailored product offering, augmented by the new Intel chip refresh cycle;

3) continued strong gross margins resulting from a favorable memory pricing curve;

4) the upcoming Analyst Day to highlight long-term growth targets and illustrate an estimated $5.93 of long-term EPS power