Description

Situation Overview

I previously wrote up SMCI in February of 2018. I encourage you to review that write-up and the comment thread for the business overview, background and context. The original thesis that the company would experience accelerating revenue growth due to the Intel Skylake server processor product cycle and rebound from its then-depressed margins from an easing of memory and other computer component costs proved correct. At the time the company had not filed its FY June 2017 10-K due to an accounting inquiry, but I was optimistic the reporting would be resolved by mid calendar year 2018. This optimism proved unfounded, as the board and the SMCI’s auditors determined that the company would have to restate its financials for FY 2015-2017. The restatement process led to an extended period of limited financial visibility and de-listing from NASDAQ. Along the way, some sensational journalism led to an unpleasant gut-check moment that ultimately resulted in a great buying opportunity. SMCI finished its very minor though costly in time and fees financial restatement in May of 2019, and filed the rest of its delinquent SEC filings in late December 2019. Yesterday, SMCI PR-ed that their NASDAQ application was approved and the stock will be re-listed as of January 14th. I am re-submitting SMCI as an idea because a lot has happened and I believe the risk/reward now is even better than when I first wrote up the stock almost two years ago. I believe SMCI could double from current prices in the next year as the company gets re-listed on NASDAQ, analyst initiations attract investor attention, passive funds purchase shares and the financial results re-accelerate as the server industry enters another Intel server processor cycle.

Accounting Inquiry Resolution

At the time of the original write-up, I believed it was possible that the company could avoid restating the first three quarters of FY 2017 and get back current with its financials prior to a NASDAQ de-listing on 8/24/2018 (a one year extension from the original due date for the FY 2017 10-K). These hopes turned out to be misplaced and on 8/21/2018 the company notified NASDAQ that it would not be able to meet the deadline and would move to the OTC market. In this announcement the company stated that it was continuing its testing of hundreds of sales transactions going back to FY 2015 to ensure that the sales were recorded on the proper dates, however, it had not found any transactions that could not eventually be recognized as revenue. NASDAQ delisted the stock on 8/24/2018.

Subsequent to SMCI’s de-listing and after extensive testing of FY 2017, 2016 and 2015 sales transactions, Super Micro’s audit committee determined that financial statements for 2015, 2016 and the first three quarters of 2017 would have to be restated. The investigation uncovered errors related to timing of revenue recognition and some inventory classifications, with none of the revenue recognition errors relating to customer transactions involving revenue that could not ultimately recognized. Obviously, these errors meant that the company had deficiencies in its internal control over financial reporting that had to be corrected. Super Micro gave a range of adjustments for the three fiscal years of a total of between -$90M and -$30M in sales, between 1.3% and 0.4% of the total revenue over the three years and less than $13M of cumulative earnings. 

I believe these restatements were caused by an organization outgrowing the capabilities of its CFO and its internal control procedures. During this process Super Micro replaced its CFO with Kevin Bauer, who previously served as the CFO of two publicly-traded semiconductor companies. Super Micro has beefed up its internal controls, ramped its G&A spending by hiring additional financial staff and appointed a new board audit committee member who was previously the CFO of publicly-traded Brocade before its sale to Broadcom (AVGO). SMCI has stated that it believes it will be able to certify its financial controls for the purposes of its FY 6/30/2020 10-K.

After a long delay, on 5/16/2019 SMCI finally filed its 2017 10-K which included restated financials for 2015 and 2016 as well. The final 2017 revenue number was near the top end of the expected adjusted revenue range and above the top end of the estimated range for net income.  The cumulative revenue adjustment for FYs 2015-2017 was a mere $72M, or about 1.1% of the cumulative $6.7B of revenue. The audit committee investigation/restatement expenses will total over $100M in accounting and legal fees to reach these minor adjustments. Super Micro then had to complete its FY 2018 and 2019 10-K and Qs, which were filed in December 2019 and conformed closely to the preliminary revenue and earnings ranges reported during the dark period. The last step to get back into filings compliance was filing the FQ1 10-Q for September 2019, and SMCI made this filing on 12/20/2019.

Fake News Attacks!

While SMCI was in the throes of its restatement process, the news media dealt the company another blow. On 10/4/2018 Bloomberg published an article entitled “The Big Hack” which purported to break the story that Super Micro’s supply chain had been compromised such that tiny spy chips were installed in its motherboards that could transmit data to Chinese Intelligence. Needless to say if true this revelation could have been devastating to Super Micro’s business. With their credibility already strained by the accounting inquiry and restatement process, the stock traded off over 50% intraday.

Suffice it to say, it did not take long for the story to fall apart as the companies named (including Apple and Amazon) in the article as having “discovered” the Chinese spy chips denied having found any such thing and computer security professionals publicly questioned the technical feasibility of the purported hack and lack of evidence. The Chinese server motherboard factory cited in the article served several computer vendors other than Super Micro, raising the question of why SMCI would be solely affected by this claimed vulnerability. 

While Bloomberg never formally retracted the story, it has also not posted any follow-ups or refuted the specific and direct denials of the companies named as victims of the hack in the story. SMCI sent a letter dated 10/18/2018 to its customers detailing why it believed the story was false. The company also commissioned an independent security researcher to investigate Bloomberg’s claims, and the firm released its report that it was unable to find any malicious hardware in December 2018. From conversations with industry participants, it appears that the story has largely been discounted as false. While the company surely spent significant resources investigating the claims and reassuring its customers, December 2018 quarterly revenue came in within expectations and up Y/Y.

Financial Results and Current Business Trends

SMCI’s engineering nimbleness enables it to quickly incorporate Intel’s latest server processor designs into a wide range of server products optimized for its customers’ specific needs. Intel releases a new server processor family approximately every 18 months in a “tick-tock” cycle, with the “ticks” representing significant fundamental architectural changes (usually in smaller process geometry manufacturing nodes) and the “tocks” representing more incremental feature improvements. While SMCI has outgrown the server market over time, in the past the business has shown more significant revenue growth outperformance during the “tick” cycles as it gains share during new architecture rollouts. Intel was in just such a “tick” processor cycle with Skylake released at the end of Q2 2017, although the processors were not shipping in significant volume until early 2018. Super Micro indeed experienced accelerated growth during the Skylake processor cycle, growing 36% in the March 2018 quarter, 37% in the June 2018 quarter and another 36% in the September 2018 quarter. The revenue came in better than I expected as SMCI took full advantage of the Skylake processor cycle to gain share. The results were all the more impressive given the significant management bandwidth taken up by the accounting inquiry and restatement process, as SMCI did not seem to suffer from the management distraction that we have seen consume other companies going through restatement processes.

While SMCI’s recent revenue growth was impressive, it was not all roses in their financials. The company suffered from the significant increases in both DRAM and flash memory prices during calendar 2017 and into 2018. DRAM and flash pricing grew substantially during 2017 and remained high during early to mid-2018 as demand growth outstripped supply. Memory prices affect SMCI because server DRAM and flash-based solid state drives are manufacturing inputs, with DRAM a larger part of COGS than flash. Indeed, GMs declined from 16% in FY 2015 to 15% in FY 2016, 14% in FY 2017 and slightly below 13% in the June 2018 quarter. The lower GMs have translated to lower pro forma operating margins, which peaked at around 8% in FY 2015 and bottomed in the low 3% range in the June 2017 quarter. Since then, memory prices have eased and GMs have recovered to the 15-16% range with operating margins climbing to the 6% range in the September 2019 quarter.

Unfortunately, the easing of memory prices has coincided with a slowdown in corporate IT and cloud spending on servers. SMCI reported -5% Y/Y revenue growth for the March 2019 as it felt this slowdown and went against the extremely difficult +36% comps for the March 2018 quarter referenced above. The slowdown will last at least through the December 2019 quarter as SMCI lapped three more quarters of very strong comps, a lull in the Intel processor cycle and the general industry softness. In their 1/9/2020 press release SMCI raised their December 2019 revenue guidance to a midpoint of $865M (up from a midpoint of $840M) which represents an approximately 7% decline. 

Forward Prospects

SMCI’s four quarters of Y/Y revenue decline during calendar 2019 is the longest stretch of Y/Y revenue declines it has experienced as far as I can tell. The company has been through several cycles of declining revenue after large revenue increases, but I believe this most recent one has been somewhat worse than usual due to a hangover from the unusually strong calendar year 2018 (SMCI grew 31% in CY 2018) and some share loss due to a combination of not having current financials and the spy chip story. However, industry conversations over the last year have left me comfortable SMCI remains well-regarded and capable, and I am confident that the company will return to significant growth in CY 2020.

SMCI will be aided in CY 2020 by a return to server industry growth and Intel’s processor cycle. Intel’s most recent family of 14 nm Cascade Lake processors began sampling in April of 2019 and it usually takes around six months for the new processor to ramp in earnest. While normally the “tocks” of the processor cycle are not as impactful, industry contacts have told me that this “tock” cycle is more significant than usual, which plays right into SMCI’s strengths in rapid engineering, SKU variety and flexibility. In fact, Intel released a second family of updated 14 nm server processors with Cooper Lake in the 2H of 2019 which should have a significant ramp in 1H 2020. Thus, I believe by the March 2020 quarter SMCI will revert to growth, so the timing for its re-listing could be perfect. Looking a bit further out, Intel’s next “tick” cycle should begin later in 2020 as the Ice Lake 10nm offering will be released on an expedited 12 month lag rather than the normal 18-24 months. Due to the expedited processor cycle and easy comps, I believe that SMCI will show Y/Y revenue growth for at least 6-8 quarters beginning March 2020.

SMCI stock should be re-listed next week, the company will be meeting with investors at the Needham conference in New York around the same time and Super Micro has stated it will hold an analyst day shortly thereafter. Over the next year SMCI should generate analyst coverage and be re-included in indexes including but not limited to the Russell 2000. What will the stock be worth then? As previously mentioned, I believe the company’s top line will return to some growth in Q1 2020 and more rapid growth in Q2 2020 based on easy comps and hitting the meat of Intel’s Cascade Lake/Cooper Lake processor cycle. At the same time, it appears likely that the memory pricing environment will be much more benign than during SMCI’s rapid growth in FY 2018. Thus by the June quarter of 2020 my model shows SMCI hitting 15.5% GMs (above the previous tough of 12.7% but far below previous peaks in the high teens) and operating margins of around 6.5% (once again above the previous trough of 3.3% but well below previous peaks of over 8%). This could result in pro forma EPS of $.90 per quarter, or $3.60 annualized. These earnings should grow in FY 2021 assuming the company continues to execute and benefits soon thereafter from the Ice Lake cycle. 

While a hardware integrator like SMCI will probably never get a premium multiple, even at a below-market 14x run-rate earnings this would equate to a $50 stock, over 100% upside to today’s prices. Obviously, with the re-listing there should be significant passive buying as the market cap should qualify SMCI to re-join several indexes. At the same time the company reported a tangible book value of around $19.40 per share in its most recent quarter, which I believe understates its true asset value due to SMCI’s ownership of significant Bay Area real estate. This low P/B value combined with profitability and cash flow may attract algorithmic value investors that previously did not include SMCI in the investable universe due to the lack of financials and major exchange listing. Needless to say in today’s market it is extremely rare to find a consistently profitable and growing technology stock trading near book value, so I believe SMCI has minimal downside.

Disclosure: The fund that I work for owns shares of SMCI. We may buy or sell shares of SMCI at any time without notice.

Catalyst

• NASDAQ re-listing
• Passive index and algorithmic investor buying
• Analyst day
• Wall Street research analyst coverage initiations
• Return to revenue growth driven by Intel processor cycles