Super Micro Computer Stock: High Risk, Higher Upside?

Super Micro Computer stock (NASDAQ: SMCI) has experienced considerable volatility this year.  Super Micro Computer is a data center solutions provider, which sells server systems, server boards, storage, networking solutions, management software, and installation and maintenance services. SMCI stock rose nearly eightfold over the past two years – from about $6 per share in September 2022 to around $47 today, driven by strong demand for servers from AI data centers as well as the recent 10-for-1 stock split.  However, the stock saw a meaningful pullback earlier this year amid concerns over gross margins, supply chain issues, and a delayed 10-K filing following short-seller Hindenburg Research’s accusations of accounting irregularities. Moreover, Ernst & Young just resigned as the company’s public accounting firm, causing the stock to drop considerably in pre-market trading on Wednesday. While the ongoing governance issues and auditor resignation, indicate that it may be prudent to be cautious with SMCI stock at this time, we present some of the key risks and positives for the company.

In our recent analyses, we argued for a range of outcomes. On one hand, there is potential for the stock to rise over 2x to $1,000. On the other hand, we presented a counter case that outlines Super Micro stock could decline to levels of about $200 per share. (These are pre-split numbers.)

Admirably, SMCI stock has generated better returns than the broader market in each of the last 3 years Returns for the stock were 39% in 2021, 87% in 2022, and 246% in 2023. In contrast, the Trefis High Quality (HQ) Portfolio, with a collection of 30 stocks, is considerably less volatile. And it has outperformed the S&P 500 each year over the same period.

Why is that? As a group, HQ Portfolio stocks provided better returns with less risk versus the benchmark index; less of a roller-coaster ride as evident in HQ Portfolio performance metrics.
Given the current uncertain macroeconomic environment around rate cuts and multiple wars, could SMCI see a strong jump?

Let’s start with the bad first

The corporate governance concerns raised by Hindenburg Research warrant close attention, though the full extent of the issue remains unclear. The short seller claims that Super Micro may have engaged in improper revenue recognition, allegedly booking incomplete sales and bypassing internal controls. Additionally, the company is accused of questionable relationships with related parties, particularly suppliers linked to the CEO’s family. Hindenburg also highlights the rehiring of executives previously involved in past scandals, shortly after the company settled with the SEC. The recent resignation of the company’s auditors also raises red flags. Ernst & Young appears to have issues with the financial statements prepared by the company, as well as the board’s independence from CEO Charles Laing  and other members of the management team.

There are concerns about whether demand can hold up. The underlying economics of the broader AI ecosystem remain questionable at this juncture, and most AI customers are still loss-making. Large language models are also expensive to build and train. We could be in an AI “FOMO phase,” where companies feel compelled to invest in AI simply because their competitors are. As Super Micro’s end customers seek better returns, we could see capital spending cool off, impacting growth. Additionally, most AI companies are currently in the compute-intensive training phase, and demand for computing power and server equipment could cool off once they transition to the less compute-intensive deployment phase. This could also hurt demand for Super Micro’s server systems, server boards, storage, and networking solutions.

Furthermore, Super Micro’s margins are also vulnerable. Although net margins expanded from 6% in FY’22 to about 9% in FY’24, driven by higher economies of scale, they could decline meaningfully if sales drop and competition mounts reducing the company’s volumes and pricing power. Moreover, SMCI has seen its gross margins face some pressure in recent quarters as it sells a higher mix of liquid-cooling systems, which are proving expensive to produce and this trend could also continue. The server market is also very commoditized. While Super Micro does have some competitive advantages, given that its products are seen as being more customizable, the company’s lead in these areas is hardly insurmountable and competition could increase considerably.

The good and the great

While the initial AI models deployed by the likes of OpenAI in 2022 were largely text-based, models are increasingly multimodal meaning that they work with speech, images, video, and 3D content – calling for higher computing power and a larger number of GPU shipments. Moreover, unlike a decade or so ago when advancements in computing power – particularly with processors – outpaced the development software that could fully utilize these capabilities, in the AI era, the demand for computing power has skyrocketed due to the intense computational requirements of machine learning models. If computation requirements continue to trend higher, Super Micro too could see demand grow as the companies infrastructure tools are required to underpin the expansion.

The shift in U.S. monetary policy could also give SMCI an extra lift. The Fed’s 50 basis point cut – the first in nearly four years – brings the federal funds rate to 4.75%-5%, with room for further reductions. Lower rates boost growth sectors like tech by increasing the present value of future earnings. The rate cuts are particularly beneficial to SMCI. Why?  Lower interest rates would reduce financing costs for builders of large data centers, potentially driving up capital spending in the space. Moreover, the economics of the AI revolution remain mixed, given the high costs of model training and inferencing. A drop in interest rates could improve the financial feasibility of these investments. Check out our analysis of other ways to profit from the Fed’s next move. 

Although the server market is commoditized, Super Micro does have some competitive advantages, given that its products are seen as being more customizable and more energy efficient than rivals.  Super Micro’s customers are also increasingly opting for more premium products. For example, the company estimates that costly liquid-cooling systems for servers, which were relatively rare in the pre-AI era, will be installed in 30% of server racks it ships next year. The company is also steadily boosting its production capacity. For example, it is building out a new facility in Malaysia that can produce over 5,000 racks of server kits every month. This gives the company to ability to scale up revenues in the long run.

So what should you do?

Answer: Add SMCI to your portfolio so that while you envision a 5x gain in the long term, you’re also willing to stomach 50% loss at any time during the ride. Yep, be willing to bear short-term pain – the price you’ll pay – to be rewarded in the long run. This sounds simple in theory but is never easy to live by in practice.

While investors have their fingers crossed for a soft landing by the U.S. economy, how bad can things get if there is another recession? Our dashboard How Low Can Stocks Go During A Market Crash captures how key stocks fared during and after the last six market crashes.

[1] Returns as of 10/28/2024
[2] Cumulative total returns since the end of 2016

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