Super Micro Computer Q1: Red Flags, Lessons Learned, And Hope Ahead (Rating Downgrade)

Summary:

• Despite beating revenue estimates in Q1, SMCI faces significant regulatory concerns, including auditor Ernst & Young’s resignation, previous SEC charges, and potential Nasdaq delisting.
• A 35.5% margin of safety exists if regulatory issues are resolved favorably; however, in a conservative scenario with negative outcomes, this shrinks to just 9.62%.
• Given Super Micro Computer’s history of accounting malpractice and ongoing scrutiny, my rating is downgraded to Hold, advising caution due to potential long-term risks.

I must admit that my experience with Super Micro Computer (NASDAQ:SMCI) has taught me a lot. To begin with, valuation is king in investing. Especially when a company is being scrutinized for regulatory misconduct of any kind, one must ensure the stock is undervalued with a significant margin of safety. In the case of Super Micro, it was unfortunately overvalued for long-term investors when current regulatory concerns first came to light. Despite the likelihood of recovering losses from the recent stock declines, this is not how one would hope to invest consistently over time. Although the current valuation is perhaps reasonable for a long-term allocation with little to no speculation in price, the risk of Nasdaq delisting amid the Ernst & Young auditor resignation is one red flag. Therefore, I am downgrading my rating to a Hold from the Buy rating I issued in my Q1 Earnings Preview.

Q1 Earnings Review: Reasonably Strong Results Amid Serious Regulatory Concerns

To begin with, the headline data: Super Micro delivered a normalized EPS of $0.63 for the quarter, missing the consensus estimate by $0.19. On the other hand, it beat the consensus revenue estimate by $4.81 million. These are reasonably strong results, but certainly not enough to sway sentiment amid the breaking news that the company’s auditor, Ernst & Young, resigned.

We are resigning due to information that has recently come to our attention which has led us to no longer be able to rely on management’s and the Audit Committee’s representations and to be unwilling to be associated with the financial statements prepared by management” (emphasis added). A statement from Ernst & Young, as quoted in Super Micro Computer’s Form 8-K, October 24, 2024.

Unfortunately, this resignation is a serious red flag, not least because the company was temporarily delisted from Nasdaq (NDAQ) once before in 2018, and in August 2020, the SEC charged it with widespread accounting violations. The question long-term value investors need to ask themselves is, “Is this really a company I want to be owning in my portfolio? How would I feel if a business that I owned outright operated in such a historically negligent manner and is now under further scrutiny?“

CEO Charles Liang stated in the Q1 earnings call that an independent Special Committee had conducted a thorough investigation into the audit concerns raised by Ernst & Young and found no evidence of fraud or misconduct—but this must be taken with skepticism, given that it was an independent Special Committee and not an officially regulated source. The committee was also initiated internally, even if the investigation was conducted by those not involved in the company’s day-to-day operations.

The results of the current scrutiny could end up being one of two things—a serious wake-up call for management to regulate its internal accounting controls more in the future for professional transparency, or a case of genuine accounts misconduct. In the latter case, we’re looking at prolonged depressed stock market sentiment and potentially large customer losses, all of which are outcomes I do not want to be exposed to in my portfolio for any meaningful period of time.

Moreover, looking at management’s future outlook, they did not provide annual guidance due to uncertainties around pending audit adjustments and chip supply. However, they did project revenue for Q2 of between $5.5 billion and $6.1 billion. If Super Micro Computer is genuinely not guilty at this time, then I expect a strong recovery over the next 12 months, which is what my valuation analysis will model, given the justified tenet that one is innocent until proven guilty.

Valuation Analysis: 35.5% Margin Of Safety Assuming No Future Regulatory Hazards

While Super Micro’s highest growth stage is behind it (year-over-year revenue growth of 110%), strong growth is likely to continue for FY25, driven by continued demand for servers and storage solutions for data center expansions.

I currently forecast that the company will achieve a total revenue of $30 billion for FY26 and, following this, a revenue CAGR of about 16.5% seems reasonable to estimate through to the end of FY30, which will be the duration of my valuation model, given the current instability in the company’s operational circumstances. This represents approximately a period of 5.65 years from now. I estimate that the company will have a total revenue of $55.3 billion by the end of FY30.

Super Micro has a current trailing 12-month (‘TTM’) EBITDA margin of 8.73%, which is significantly higher than its five-year average of 6.76%. The company has managed to achieve this through economies of scale related to focusing on its high-value segments, such as AI infrastructure. That said, with demand from this segment likely to taper over my time period, a reversion to the mean is probable. Therefore, my terminal EBITDA margin estimate is 7.75%, which is the median of its TTM and five-year average. Therefore, I estimate the company will deliver an FY30 EBITDA of $4.29 billion.

The company has a five-year average EV-to-EBITDA ratio of 16.16, but this reflects the large growth period it delivered in 2024, which is unlikely to be repeated. The company’s 10-year median EV-to-EBITDA ratio is 11.28, and it is currently 12.71. Due to its EBITDA growth likely to be similar to long-term historical pre-upcycle levels moving forward, I am using a terminal EV-to-EBITDA multiple of 12. Therefore, my forecast for Super Micro’s 2030 enterprise value is $51.48 billion. This is a significant reason to potentially buy the stock right now, given that its current enterprise value is $16.72 billion, indicating a 207.9% upside potential.

It is also worth discounting this back to the present-day value over 5.65 years. Super Micro Computer’s weighted average cost of capital (‘WACC’) is 12.92%, calculated using an equity value of $13.29 billion, one-year quarterly average debt of $975.07 million, a cost of equity at 13.73%, and a cost of debt at 1.98%, adjusted for a 4.94% tax rate. I will be using the company’s WACC for my discount rate. The present-day intrinsic enterprise value of Super Micro Computer is $25.91 billion if considering holding the stock for 5.65 years until the end of FY26. This indicates that the investment currently has a 35.5% margin of safety based on an optimistic Department of Justice (‘DOJ’) outcome, given its present enterprise value of $16.72 billion.

Risk Analysis: Regulatory Hazards Could Prove Detrimental

It’s worth remembering that the above intrinsic enterprise value estimate is highly optimistic, given that it depends on a positive outcome of the current regulatory investigations that the company faces. If delisted from the Nasdaq, Super Micro would also be removed from major indices like the S&P 500 (SPY), meaning it would lead to forced selling of passive investment funds that track these indices. A Nasdaq delisting would also mean the company has limited access to capital through equity raising, and also faces a higher cost of debt due to the increased risk profile of its business.

A prolonged period of reputational losses for Super Micro in the face of a negative DOJ investigation outcome and potential fines from the SEC could open up weakness for competitors like Dell (DELL) and Hewlett Packard (HPE) to capitalize on. Both competitors have been aggressively expanding their AI server offerings, and they could seize this opportunity to attract customers who are hesitant to continue working with Super Micro amid legal uncertainties.

I believe the market has already begun to significantly price these risks into the stock, which is why the company is currently undervalued in my above model. That said, with a lower FY30 EBITDA of $3.5 billion and trading at an EV-to-EBITDA ratio of 10.5, the FY30 enterprise value would be $36.75 billion. When discounted back over 5.65 years with its WACC of 12.92% as the discount rate, its present-day intrinsic enterprise value is $18.50 billion. Given its present enterprise value of $16.72 billion, this indicates the investment has a 9.62% margin of safety in a conservative negative DOJ outcome. Therefore, Super Micro stock is likely a Buy right now for value investors happy to take on the extra risk. Yet again, my question is, “Why take on the risk if the ethics are not black and white?”—this is my big takeaway from my experience as an analyst with Super Micro Computer. Given the current uncertainties and track record—even with a potential 15% CAGR in enterprise value over five and a half years in a conservative negative DOJ outcome—I prefer not to own stakes in companies that have a history of accounting malpractice and ongoing concerns, including the resignation of a reputable auditor like Ernst & Young.

Conclusion: Hold

There’s hope ahead for Super Micro Computer, but it’s not a path without uncertainty. Given the current climate of intense scrutiny for the company, investors who want to get high growth from AI would be wise to look elsewhere for companies that do not show signs of reputational hazard ahead. Given that my bear-case outcome above is conservative, one can speculate what a worst-case scenario would look like for Super Micro’s enterprise value. Amid current tensions, it seems prudent to rate the stock a Hold—and to take the lessons learned from the company’s dubious recent conditions into future investing endeavors.

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Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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