Super Micro Computer (NASDAQ:SMCI), also known as Supermicro, is a high-performance server company that has garnered a lot of attention from investors this year due to being among the largest beneficiaries of Enterprise demand for innovative technologies like 5G, Edge computing and generative Artificial Intelligence (“AI”). Maybe the only company that has benefited more from those secular tech trends this year has been NVIDIA. Both companies are among the best performers in the stock market this year.
You might think that a stock up triple digits for the year would be wildly overvalued, especially since Supermicro competes in the low-margin server industry against many rivals, some of them much larger. However, I will make the case in this article that the company remains undervalued to its expected growth. I will also discuss the company’s growth drivers and why the company is grabbing market share from market leaders like Dell Technologies (DELL) and Hewlett Packard Enterprise Company (HPE). If you are looking for a long-term growth opportunity that can outperform the market, regardless of short-term economic fluctuations, consider putting this company on your buy list.
How the company is winning
Supermicro’s growth lagged slightly behind the pace of the server industry until mid-2021. In the era where companies mostly used servers for web hosting, email, database, application hosting, and gaming, it was just another uninspiring company selling an undifferentiated product. My how times have changed.
The pandemic sped up the adoption of the cloud, high-performance computing, and AI. As businesses raced to differentiate in the post-pandemic era by being the first to adopt the latest technology, Supermicro’s ability to deliver new technologies to the market quickly stood out. In past interviews, the company’s Chief Executive Officer (“CEO”) Charles Liang has talked about how it designed its products based on “building block solutions,” which enables the company to build application-optimized, high-performance, high-efficiency server and storage systems faster than the competition.
Supermicro’s building block solutions or modular approach also enables customers to select their servers’ processor, memory, storage, and networking components. While some competitors allow customization, it is hard to think of any that have as low a lead time to fulfill a customized order. In a market where companies want to deploy the latest solutions from NVIDIA (NVDA), Advanced Micro Devices (AMD), and Intel (INTC) to gain an edge over competitors, delivery speed becomes a competitive advantage.
Another thing to note on the above chart is the company’s rise above the server industry’s growth rate coincided with Supermicro’s shift from a Sub System and Total System provider to a Total IT Solutions @ Rack Scale provider. What this means in a language the average person can understand is that the company has transitioned from only providing parts of a server system to providing a complete hardware and software server solution specifically designed for customers to deploy Cloud, AI, and 5G/Edge applications. Supermicro developed its Rack Scale systems as modular, future-proofing the system. Individual server components can be easily added, removed, or upgraded. Suppose NVIDIA makes a vastly superior Graphics Processing Unit (“GPU”) two years from now; customers can easily upgrade to the new GPU simply by changing a module.
During the company’s first-quarter fiscal 2024 earnings call, the CEO said:
Our position as a leading supplier of rack-scale plug-and-play Total AI and IT Solutions has just begun. Our growth will accelerate as we deliver more optimized AI infrastructure to existing and emerging markets, along with our growing software and services value.
Source: Super Micro Computer’s First Quarter Fiscal 2024
The proof is in the pudding. The company has run past the performance of the rest of the server industry over the last two years and snatched market share as the Cloud, AI, and Edge computing have proliferated. The chart below shows that Supermicro’s year-over-year quarterly revenue growth has outperformed the largest server company by revenue, Dell, with a 19.3% share, and the second largest, Hewlett Packard Enterprise, with a 13.0% share. Supermicro has a 5.3% share as of 2022.
If the Cloud, AI, and Edge computing markets are indeed in the early stages of a substantial secular growth run, Supermicro’s outperformance should continue in line with those markets.
Green Computing
Green computing is more than a fad for Supermicro. It has been a leader in building energy-efficient servers and reducing carbon emissions for over two decades. Its customers also benefit as lowering energy consumption reduces the Total Cost of Ownership, known as TCO. Lower server TCO costs help companies save on infrastructure costs and increase profitability, making Supermicro’s servers far more attractive than the competition’s offerings.
With the rapid adoption of generative AI, the demand for more efficient data center cooling has risen through the roof, as the technology consumes a lot of power and generates a massive amount of heat. According to CEO Liang on the first quarter fiscal 2024 earnings call:
As most people know, the power consumption and thermal challenges of these new AI technologies have risen dramatically. We are now shipping up to 80-kilowatt rack solutions, with 100-kilowatt rack just around the corner, for compute-intensive datacenter, CSP [Cloud Service Provider] and other industries. Our high-power efficiency systems, free-air and liquid-cooling expertise has become one of our key differentiators of success. I anticipate that up to 20% or more of global datacenters will transition to liquid-cooled solutions in just a few years.
Source: Super Micro Computer first quarter 2024 earnings call.
Supermicro is very advanced in liquid cooling, which is light years ahead of air cooling in efficiency. The company claims on its website that liquid cooling can remove heat up to 1000 times more effectively than air cooling, reducing a company’s operating expenses by more than 40%.
Bloomberg Intelligence forecasts the generative AI market to expand from $40 billion in 2022 at a Compound Annual Growth Rate of 42% to $1.3 trillion in 2033. If that pace holds, the need for green computing should continue to grow, driving demand for Supermicro’s innovative cooling solutions.
Great fundamentals
Other Seeking Alpha analysts have reviewed the recent earnings here and here and were impressed with the company’s “beat and raise quarter.”
The CEO let investors know right off the bat in the earnings call that despite being handicapped by shortages of components such as GPUs, CPUs, and memory, robust demand for AI platforms drove Supermicro’s growth revenue in the first quarter, specifically its new “plug-and-play rack-scale for the Large Language Model-optimized NVIDIA HGX-H100.” Chief Financial Officer (“CFO”) David Weigand also said, “Next generation AI and CPU platforms continue to drive strong levels of design wins, orders and backlog,” giving confidence that revenue growth will continue. Its strength in AI platforms also helped it outperform the downturn in the traditional server industry.
It grew fiscal first quarter 2023 revenue by 14% over the previous year’s comparable quarter to $2.12 billion, beating analysts’ consensus estimates by $57.20 million. It gave guidance for the second fiscal quarter of between $1.9 and $2.2 billion, up approximately 11% from last year’s second quarter at the mid-point of guidance. Management also surprised investors by raising year-over-year full-year fiscal 2024 guidance from its 40% midpoint projection made in the fiscal fourth quarter of 2023 to its new first quarter estimate of 47.5% growth at the mid-point between $10 billion and $11 billion.
Some of Supermicro’s optimism likely stems from its plans to “expand its total rack production capacity to 5,000 racks per month by the end of the March quarter,” according to the CEO on its first-quarter earnings call. Additionally, in response to the initial question in the question-and-answer portion of the first quarter earnings call concerning NVIDIA shifting chip production from China to Supermicro since the U.S. government banned AI shipments to China, the CEO said:
But at this moment, we believe December quarter, our supply from NVIDIA will be much better than last quarter. And that’s one of the reasons why we are able to fulfill more percentage of customer demand and that’s why we say, $2.7 billion to $2.9 billion should be our target.
Source: Super Micro Computer Fiscal First Quarter Earnings Call
The company also highlighted a whole slew of new products coming on to the market optimized for generative AI, inferencing AI, and telco-optimized edge products that include the NVIDIA GH200 Grace Hopper and Grace CPU Superchip-based products and various products from Intel and AMD, as seen in the below image.
Supermicro produced diluted generally accepted accounting principles (“GAAP”) earnings-per-share (“EPS”) of $2.75. Non-GAAP diluted EPS came in at $3.43, beating analysts’ estimates and higher than the midpoint of the company’s guidance range of $2.75 to $3.50. The CFO attributed the outperformance to “stable gross margins, lower non-GAAP OpEx [Operating Expenses] and foreign exchange gains.” The company produced positive free cash flow (“FCF”) of $268 million in the first quarter, rising from the negative FCF of $17 million in the fourth quarter of 2023.
Supermicro ended the September quarter with $543 million in cash and short-term investments against $146 million in bank debt. It paid off $144 million of that debt during the quarter. Supermicro has a debt-to-equity ratio of 0.07, indicating a solid balance sheet. It has a current ratio of 2.23. A current ratio above one often suggests that a company can pay its short-term financial obligations.
This report was solid and a reason why some investors remain bullish on the company.
Risks
The company’s ability to satisfy demand for its server solutions is partially out of its hands. Supermicro may have the manufacturing capability to meet demand. Still, if a component supplier cannot supply Supermicro with enough parts, it can crimp its manufacturing capacity. When you see Supermicro management talk about “supply chain constraints,” it means they don’t have enough components to build enough servers to satisfy demand. For instance, Supermicro’s production capacity has been hampered recently by the inability to get enough graphics processing units (GPUs) from NVIDIA. In the medium term, NVIDIA’s plan to triple GPU production in the calendar year 2024 should help resolve the problem of not getting enough parts from NVIDIA. If something goes wrong and NVIDIA cannot deliver, Supermicro could underperform expectations.
Another risk that investors should also pay attention to is competition. Supermicro has fierce competition in a fragmented server market. The company has larger and smaller competitors that may eventually replicate its key differentiating factors, such as using a similar modular building block approach, focusing on green solutions, and bringing the most recent technology first to market.
Last but not least, Bloomberg released a story in 2018 alleging that Chinese spies installed a spy chip in Supermicro servers that infiltrated many U.S. corporations. Afterward, Supermicro and others denied the report was accurate. Still, the company moved its manufacturing operations outside China to alleviate customers’ concerns in 2019. Undeterred, Bloomberg doubled down by publishing another story in 2021, claiming once again the spy chip allegation was true. Supermicro, Apple, Amazon, and the National Security Agency again debunked the report. Although this news story failed to hurt Supermicro’s business long-term, it cannot afford any more scandals or accusations of security breaches.
Valuation
The chart below shows consensus analyst EPS estimates for fiscal 2024 call for 48.95% year-over-year growth, yet the consensus forward price-to-earnings (“EPS”) ratio is 15.12. I consider this valuation far too low for the earnings growth expected this year.
The chart below shows consensus analyst revenue estimates for fiscal 2024, calling for 52.18% year-over-year growth, yet the consensus forward price-to-sales (P/S) ratio is 1.31. Its estimated forward revenue growth rate is remarkably high, indicating that analysts expect the company to grow rapidly this fiscal year. A forward P/S ratio of 1.31 for a revenue growth rate of this caliber suggests the company is trading at too low a valuation relative to its revenue growth potential.
The market may also undervalue the stock according to its trailing 12-month (“TTM”) P/S ratio. Seeking Alpha shows Supermicro’s TTM P/S ratio is 1.91, below its sector median ratio of 2.50. Suppose you multiply the company’s first quarter fiscal 2024 revenue per share of $130.68 by its sector median ratio of 2.50; it would show a fair value of the stock as $326.70, about 23% above its closing stock price on November 10.
Wall Street analysts are far more optimistic and rate the stock as a buy with a price target of $375.20, a potential upside of 41.04% from Supermicro’s closing price on November 10, 2023. Some may have thought they missed the boat after the stock’s massive run so far this year. Still, the stock sells at a valuation with an excellent potential upside.
Should you buy it?
Supermicro, riding on the coattails of some of the best secular growth stories in the tech industry, such as the adoption of cloud computing, analytics, generative AI, and edge computing, has helped it to outperform its industry and the overall market despite the poor macroeconomy. Consider buying the stock today if you are an aggressive growth investor looking for a potentially high-upside opportunity. I recommend Supermicro stock as a buy.
