SuperMicro (SMCI) Long – $8.70

Market Cap: $340MM; EV: $280MM

 

SMCI is a recent tech IPO that has gotten no respect and presents a rare opportunity to buy a profitable, fast-growing tech company at a single digit multiple. The company has been growing revenue organically 20 – 30%+ over the past several years and has been profitable every year since it was founded 14 years ago. The stock trades at 9X our lowball earnings estimate (ex cash) for the current fiscal year ending June 2008. For FY 2009 (ending June 2009), we believe the company can earn north of $1.05 (excluding interest and including options expense). At $8.75 and with $1.50 per share in cash, that puts the stock at 7X FY 2009 EPS. Only one analyst covers the stock and management is extremely conservative.

 

SMCI is a server / server component company that competes with more established players like Dell and HP. Many people compare it to Rackable (RACK), which has had its problems recently. But SMCI is a completely different business with a much more diversified customer base.

 

We typically wouldn’t bother looking at a company like this. On the surface, the business seems too competitive and we’d expect any primary research to yield 100 different opinions about the company’s future. But it seemed cheap enough to warrant a few phone calls. So we started calling SMCI’s large distributors and were amazed by the consistency of the positive comments we heard. Every single distributor we spoke with expected accelerating growth from SuperMicro products (meaning they expect 2008 growth to be greater than the growth they see in 2007). The median response for expected 2008 growth was 20% vs. 15% in 2007. Note that significant incremental sales growth beyond this has come and should continue to come from the company increasing direct sales as a percent of the total.

 

The company’s competitive advantage centers around its innovation and speed to market. They do not necessarily compete on price but rather offer “application optimized” solutions—customized servers designed to perform for specific needs (processing power, input/output speed, memory optimization, etc). We consistently heard that SuperMicro offers superior service and products for mid-size enterprises who are not big enough to be meaningful customers for Dell. We consistently heard that there is surprisingly little competition in this niche. We found this hard to believe initially, but we really urge you to call a customer / distributor or two so you can hear for yourself what they have to say.

 

New products and product cycles at Intel drive the business for SuperMicro, so gross margins are lumpy (have ranged from 14.7% to 21.5% in any quarter over the past several years). There are numerous reasons why we expect margins to increase. The street is projecting gross margins in the low 18% range for the next couple years (taking the low end of management’s conservative margin guidance). We think this is too low. Below is a chart of historical margins, including our conservative guess for 2008.

 

 

To explain the variation in margins in the above, FY 2006 represented the last major Intel processor upgrade, which is typically on a two year cycle (note the good margins in FY 2004). In FY 2007, which was an “off” year for Intel, the company started serving the Internet data center market and had two quarters where it had trouble sourcing components. Those problems are now solved. Gross margins in the past two quarters were 18.0% and 19.6%, both solid numbers. But both were actually artificially low because of higher than usual inventory write-offs, which we do not believe will continue at these levels. You can see that adjusted for inventory write-offs, gross margins are almost hitting highs, despite the fact that the new Intel processors won’t be released until late FY 2008 or early FY 2009.

 

 

 

The following things will continue to drive margins higher:

 

 

Factoring in these benefits and the upcoming Intel product launches, it’s hard to imagine that we should expect margins in the 18.2% range going forward as the street has modeled. We very conservatively model 19% gross margins for the current FY 2008 (remember, Q1 margins were 21.2% excluding the inventory write-down, 20.1% adjusted for the “excess” write-down above a normalized amount) and come to a GAAP EPS of 77 cents. On a non-GAAP basis (excluding stock option expense), to be comparable to current estimates, this is around 84 cents (vs. Needham at 77 cents). We don’t see any reason why margins can’t be 20%, which adds another 9 cents to our estimate. There is some theoretical limit on gross margins given the competitiveness of the industry, but the company is far from its scale potential, so there should be significant room to go. Obviously a successful software product introduction changes everything.

 

Opex was a bit higher than we expected in Q1, much of this due to a one-time R&D charge related to the introduction of new products. We expect that once the company shows further significant operating leverage (which could happen as soon as next quarter, with revenue guidance up 12% sequentially), they will start to get a growth multiple.

 

The stock is worth at least $15 (15x CY 2008 earnings of 90 cents or more, plus cash) today and more if our research is right about accelerating revenue growth (or even just continuing anywhere near the 20% range). FY 2009 should be a big year for revenue and margins given Intel’s expected processor rollout. Once SMCI is “discovered,” it’s not hard to see the stock north of $20 within a year.

 

Risks:

 

Two major things bother everyone. The first is that RACK is really one of few comps people can think of. We have also done work on RACK in the past. The company serves a much more competitive Internet data center market and has huge customer concentration issues. Its top two customers in Q2 were 54% of revenue. During 2006, the top three were nearly 70%. SMCI currently has no 10% customers. RACK is not profitable and not growing nearly as much as SMCI, but both companies trade at around .5x 2008 projected revenue.

 

The second issue is that 20 – 30% of SMCI’s COGS is paid to a related party contract manufacturer called Ablecom (which is run by the brother of the CEO and owned by the CEO’s family). We don’t like this but are comfortable that it’s not such a big deal. The bankers did significant diligence on this prior to taking the company public. The company has other contract manufacturers and operates with Ablecom at similar pricing.

 

Yesterday (11/5) was the first day employees can sell since the IPO. There are several that have been with the company for 10+ years and seem to want to get paid. We think this is creating a huge opportunity in the stock. Most of these potential inside sellers are engineers (not necessarily valuation experts) and ought to have some desire to diversify their holdings after so long. We don’t have much insight into how much stock is for sale now, but from past conversations with the CEO/founder, we don’t think much or any of it will come from him.