The History Of My SMCI Coverage
Looking back, I find it hard to believe that I initiated my coverage of Super Micro Computer, Inc (NASDAQ:SMCI) with a "Strong Buy" rating back on December 06, 2022, when 1 share was trading at $83.35:
Back then, 2 years ago, few people would have thought that this company could become a real multi-bagger. My estimates of growth potential were also far below what SMCI has actually shown in recent months.
Anyway, I continued to cover the stock regularly and finally recommended investors trim their position on June 13, 2023. Since then, I have recommended that investors hold the stock but not increase their allocation to it. Do I have to say, I was very much off track?
What Now?
Exactly 3 months, i.e. a whole quarter, have passed since my last update on SMCI stock, and since my last "Hold" thesis it has risen by around 339%. I underestimated the company's growth potential - I have to admit that. And from what I see today, SMCI's growth potential is getting even bigger: There are some very important metrics that I missed initially, but which should not be ignored today. Let me explain.
Why Do I Upgrade This Multi-Bagger?
As we can see from the company's press release that saw the light on January 29, 2024, SMCI's Q2 FY2023 revenue amounted to $3.66 billion, which is 73% and 103% higher than last quarter and last year, respectively. However, there was also a decline in gross margin from 16.7% in Q1 to 15.4% in Q2 FY2024 (last year's Q2 was 18.7%). It happened because the firm's existing operating leverage was not sufficient to offset the increase in COGS (+75.6% QoQ and +111.5% YoY).
Despite the slight margin contraction, SMCI's net income saw a substantial increase to $296 million (+89% QoQ and +68% YoY). So the diluted EPS rose to $5.10 compared to $2.75 in the previous quarter and $3.14 in the same quarter of the previous year, beating the consensus estimate by a very healthy margin:
What clearly became the starting point for a new stock rally in the weeks following the report was the massive increase in SMCI's management forecasts:
For fiscal year 2024 ending June 30, 2024, the Company is raising its guidance for revenues from a range of $10 billion to $11 billion to a range of $14.3 billion to $14.7 billion. [i.e. the guided mid-range was increased by around 38%]
Source: Q2 FY2023 results press release (emphasis and notes added by the author)
As Argus Research noted in its recent report [proprietary source], Super Micro has been growing earnings at a CAGR of 53% in recent years, while the tech industry earnings were growing at low double-digit percentages. SMCI's existing dominance over other industry players is particularly evident from the company's IR presentation:
The rise of generative AI technologies drives exceptional demand for SMCI's optimized rack-scale solutions. As a result, Supermicro is poised to achieve extraordinary revenue growth of over 100% for FY2024:
In my view, the management pursues a high-quality development strategy for the company. The focus is on developing components for x86-based systems that offer features and capabilities that other vendors do not have by being first to market with the latest AI innovations. Having worked with Nvidia and other semiconductor companies for years to incorporate the latest generation of products into its server and storage solutions, Super Micro's expertise in the use of liquid-cooled server racks appears to be the key competitive advantage. Liquid cooling, commonly used in supercomputing, offers more efficient cooling for multi-rack servers compared to air cooling. With the increasing importance of AI hardware, SMCI offers fast, innovative, and environmentally friendly liquid-cooled racks in a variety of designs.
The growing demand for the company’s products is clearly reflected in the balance sheet and cash flow statement: The operating cash outflow of $595 million in the second quarter was the result of an immediate increase in receivables and inventories on the balance sheet.
In general, the Q2 results left only positive emotions: Sales continue to grow and break new records. The decline in gross profit margin seems insignificant, and although operating leverage still can't be called strong, a significant part of sales growth is transferred to EPS growth, which is good. And most importantly: Customers are buying more goods from the company and SMCI is increasing production of those same goods like never before to meet demand. Judging by the expansion plans and raised guidance, this is just the beginning.
I remember back at the end of 2023, Super Micro's management saw the potential to increase its annual revenue to $20 billion in the span of the next few years. If we now open the last presentation, we already see a target of $25+ billion:
As stated in the earlier mentioned report by Argus Research, Super Micro's revenue growth is following a pattern similar to that of Apple (AAPL), Amazon (AMZN), and most recently Nvidia (NVDA): the firm's revenues are increasing at a significantly faster rate than its costs, setting the stage for substantial earnings expansion. Given the current growth trajectory, I expect SMCI to be on track to reach the $25 billion sales milestone by the end of the 2028 financial year, despite a potential slight slowdown in the industry's growth due to a moderate cooling of its cycle.
Now I propose not to deviate from this assumption and try to develop the idea in the format of a simple DCF model.
I'm going to assume revenue figures roughly in line with what the Wall Street consensus is now suggesting (except for FY2026 where I see a higher growth rate). I'm going to try to trust the consensus on this one, because SMCI has gotten quite a bit of attention lately, and I think the plethora of predictions that have fallen on the company from the Street make the consensus numbers smoother and closer to the truth than they were before.
Also, I expect SMCI to gradually achieve margin expansion to 16% by the end of the final forecast year. I also extrapolate D&A as a % of sales to near historical norms while factoring in growth in CAPEX as a % of sales (the company will need to spend more if it wants to maintain optimal growth rates).
Predicting changes in net working capital is always a very thankless task, doomed to a big miss in almost any outcome. But let's think logically: the current rise in current assets (and therefore NWC) is temporary. In any case, it will eventually have to give way to a decline when demand for the company’s products is saturated and it is no longer necessary to keep the warehouse fully stocked and sell to everyone on credit. Therefore, I will assume a smooth normalization of this metric to historical norms for Super Micro.
Here's what I get as an intermediate model output:
Now let's calculate the WACC of SMCI. According to YCharts, the yield on the 10-year government bond at the time of writing is 4.11%, which is the risk-free rate I am assuming. A spread of 2% is assumed for the cost of debt and the traditional 5% for the market risk premium. So Super Micro's WACC turns out to be around 10.4% - I consider this metric to be somewhat too high, but I leave it unchanged to comply with the principle of conservatism.
The last point we need to look at is the exit multiple. FinChat's DCF template provides us with the EV/FCF by default, and in SMCI's case, this metric is over 80x today [based on YCharts data]. But we need to roughly envision the company by the end of 2028 and estimate what EV/FCF ratio it could be bought for. I think the range is between 35x and 40x because the revenue growth, even though it drops to 5% in the last forecast period based on my model, should happen amid the company's increasing margins. So the premium should be there.
Based on all of the above assumptions, the SMCI stock's undervaluation equals 29%, which is even higher than Argus Research's price target of $1350.
At this point, I would like to remind you that this conclusion was reached against the backdrop of a WACC of over 10% and deliberately slightly underestimated assumptions for sales growth this year and next. I therefore have no choice but to upgrade the stock back to "Buy" again.
What Can Go Wrong With My Thesis?
The biggest risk to my thesis is the DCF assumptions I use as the basis for my calculations of the company's fair value. This is especially true for such subtle nuances as calculating changes in NWC, margins and especially the EV/FCF exit multiple. Don't forget that Cisco (CSCO), often compared to SMCI or NVDA nowadays, was trading at an even higher EV/FCF than the current AI-related names. Ultimately, however, the actual "exit multiple" dropped significantly a few years after the tech boom at the beginning of this millennium and is now just over 13x:
If we assume that SMCI's exit multiple drops to 25x instead of 37.5x in the mid-range I assumed in my model, then we get an overvaluation of just over 10%, which radically changes my thesis.
Therefore, when monitoring my thesis in the coming days, I'd pay particular attention to how much the actual figures will deviate from my key assumptions such as sales and margins. I hope that the actual numbers will systematically outperform the forecast - then my conclusions will have a greater chance of success.
Another risk lies in the extent to which SMCI has skyrocketed and in what a short space of time. Not every company is capable of showing 10x in its stock price in less than 2 years, but there are even fewer that can maintain this growth. Today I see a serious risk of mean reversion - keep that in mind if you buy SMCI above $1000 a share:
The Bottom Line
The risks of buying Super Micro after the stock has risen so far are indeed great - in such situations, investors are always afraid of landing at the top and going down the hill. However, if we talk about the next 3 to 5 years, I think that after the consolidation that SMCI has to go through now, we will most likely see higher price levels than today. My DCF model, without being too optimistic, showed a very good upside potential even for today's overbought stock price [based on many technicals]. To overcome the fear of "buying on the top ", I recommend active investors to either use options strategies or simply wait and see as recommended by market gurus. In the meantime, I am upgrading SMCI to "Buy" this time.
Thanks for reading!
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