Super Micro: Sandwiched In The AI Trend

Super Micro, also known as Supermicro, is sandwiched in the AI trend between hyperscalers and major chip design companies. The company is a server maker that started off by making motherboards and other components before it began making complete systems. The company is unique in that it sits between being an equipment manufacturer (Dell, HP) and being a design manufacturer (Foxconn).

The company competes with Dell, IBM, Hewlett Packard, and China’s Inspur. The chart below gives you a general idea of the landscape although Supermicro has doubled its revenue since 2021. The server maker is now a $6.8 billion company and ended 2021 as a $3.5B company (Counterpoint estimates were about $1B off) but the chart below is useful in visualizing the competitors.

The word “competitor” is being used loosely here as many of these companies will not necessarily be able to compete on liquid cooling for AI development platforms, or with Supermicro’s Building Block design. The companies pictured above have stagnated and this has worked out for Supermicro, a company that could have stagnated but continued to innovate instead.

According to IDC, the worldwide server market forecast is expected to deceleratedecelerate from 20% to 0%. Supermicro declined in revenue going into 2023, however, according to management, this is due to supply chain issues. This is important to distinguish as the 2023 bull case for Supermicro rests on the high demand the company is seeing, that due to supply chain issues, the company is unable to fill. The prevailing bull thesis is that Supermicro’s supply chain issues will ease in the near term.

According to the most recent Investor’s Presentation, Supermicro grew 5X faster compared to the industry average for subsystems and server systems. While there is pressure for tech management teams to cut costs, Supermicro may be more insulated by working closely on making AI systems with the most cutting-edge chips. This includes AMD 4th Generation Zen Epyc processors, Intel Xeon and soon Sapphire Rapids, Nvidia Grace CPUs and Ampere Arm-based third-gen CPUs, Nvidia’s A100 and H100s GPUs, AMD’s MI250 and MI300 GPUs and Intel’s Ponte Vecchio GPUs.

Another piece to the bull case for Supermicro is the near-term goal to reach $10 billion, which will put the company behind Dell and Hewlett Packard. Should the company reach its $20 billion long-term goal, then it could very well be the leader or at least a strong rival to Dell and HP. If/When this happens, it’ll be due to AI systems. It was stated on the call that AI/GPU and rack-scale solutions represented 29% of our total revenue and the company expects “significant future growth.”

Supermicro’s revenue quickly accelerated last year due to one large customer in Q3 2022 to Q1 2023. This one large customer, which was later identified as Meta, accounted for upward of 20% of revenue in June and September of 2022. By December, Meta had accounted for 10% of revenue. This was the subject of a short report. However, if you invest in a small cap or low mid-cap semiconductor company, there is going to be high customer concentration.

There was also a hint on the call that another customer may be ramping: “an existing Cloud Service Provider customer represented more than 10% of revenues for the first time.”

Liquid Cooling

As the performance of CPUs and GPUs increase, the heat these systems generate increases. Liquid cooling is becoming a popular alternative to air cooling to sustain maximum performance with the added benefit of driving down costs for supercomputers. According to a press release in 2021, liquid cooling can improve data center power usage effectiveness (PUE) and total cost of ownership (TCO) “by over 40% on power costs.”

Here's a quote from the CEO on the importance of this competitive advantage:

“The power consumption and thermal challenges of these new technologies have risen dramatically and 40KW or even 80KW rack solution demands are getting stronger and popular for computing hungry DC and industries. Having high power efficiency and air/liquid thermal expertise has become one of our key differentiators of success.”Having high power efficiency and air/liquid thermal expertise has become one of our key differentiators of success.”

In 2022, Supermicro stated that liquid cooling is being used in 10% of supercomputers but will grow to be used in the “vast majority” in order to offset the heat generated by power-consuming components. The company offers Direct to Chip cooling, Immersion cooling and Rear-door Heat Exchanger cooling. This design works better than air cooling, which needs air conditioning and server fans to run constantly.

Direct to Chip Cooling: Running a cold liquid over the top of a running chip by using a pump to circulate liquid. This is a closed loop system, or also known as a self-contained cooling system.
Immersion Cooling: The system is immersed in liquid for cooling.
Rear Door Heat Exchanger: Uses a specialized rear door to the rack where coolant absorbs the heat.

Water removes heat better than air. Liquid molecules are closer together than air molecules, which results in higher heat transfer. Artificial intelligence/Machine Learning and Big Data require massive amounts of data processing, and as future generations of CPUs and GPUs are released, these systems will exceed air cooling capacity.

Liquid cooling also solves CPU throttling, which occurs when CPUs and GPUs overheat and are throttled back to avoid damage to the chip.

AI Development Platforms

AI development platforms remove the need for disparate hardware and software by offering an end-to-end platform. Supermicro has partnered with Nvidia to offer Certified systems with the new H100 GPUs for the Nvidia AI Enterprise Platform.

These systems come with 3-year AI enterprise software subscriptions, and include workflows, frameworks, pretrained models and infrastructure optimization, in the cloud, in the data center and at the edge.

Supermicro is closely partnered with Nvidia on the H100 GPU rollout with air flow designs that reduce fan speeds, lower power consumption, lower noise levels and lower the total cost of ownership.

The most recent system announced in March enables AI workloads to be run in offices and the system can be rack-mounted, as well, for data center environments. The self-contained cooling system reduces operating expenses and helps the machine to run quietly for AI, deep learning, machine learning and high-performance computing (HPC) applications.

Supermicro is able to deliver workload optimized products quickly because of its building block design. The AI market is moving quickly, and SMCI can build and validate systems partly due to a modular design that allows systems to be updated from new products, such as when Nvidia, AMD or Intel have new design releases.

Financials:

Supermicro saw strong price action due to strong guidance for next quarter and due to strong guidance of 20% revenue growth for fiscal year 2024, which begins in July.

The current quarter revenue and EPS missed management guidance and analyst estimates. SMCI reported $1.28 billion for fiscal Q3 growth of (5%), which missed guidance of $1.48 billion, at the midpoint. GAAP EPS was $1.53 and Adjusted EPS was $1.71. This compares to management guidance of: “GAAP diluted net income per share of $1.75 to $2.02 and non-GAAP diluted net income per share of $1.88 to $2.14.”

This was Supermicro’s first miss dating back to 2019. Management said the following about the miss: “The shortfall was primarily due to key new component shortages for Supermicro’s new generation server platforms which have been mostly resolved to-date.”

The fiscal Q4 revenue guide was for $1.7B to $1.9B, which is above the $1.64B that analysts were expecting. The EPS forecast form management is for $2.21 to $2.71, compared to analyst expectations of $1.76.

Per the earnings call: “If supply conditions improve sooner, we expect to be above that range, despite some economic headwinds ahead. In other words, I continue to expect our fiscal year 2024 revenue to be at least 20% year-over-year growth and we are accelerating to reach our mid- to-long-term growth objectives of $20 billion per year.”

According to a previous earnings call, the CFO stated: “GPU prices and CPU prices are going up, especially with the new refreshes that are coming out. So we anticipate that [average selling prices] will continue to go up.”

At 20% growth, the company will surpass $8 billion in revenue next fiscal year, ending in June. The FY2025 analyst estimates are for growth of 11%.

Margins:

Server solutions and systems come with thin gross margins. Despite thin margins, Supermicro is a company with strong earnings with EPS of $10.73 for FY2023. Please see below for questions from analysts on the call regarding gross margin.

Gross Margin of 17.6% compares to 15.5% in the year ago quarter. The company stated GM was lower due to product mix and new platform ramps.
GAAP operating margin of 7.7% compares to 6.6% in the year ago quarter. This is lower compared to previous quarters this year in the 9% to 10% range. The company stated it was lower due to lower revenue.
GAAP net margin of 6.7% is up from 5.7% a year ago. This is lower compared to previous quarters this year in the 9% to 10% range.

Cash Flow:

The company reported strong cash flow in the current quarter with a margin of 15.5% for operating cash flow and 14.8% margin on free cash flow. This equals $198 million and $190 million, respectively. There is $362 million on the balance sheet and $187 million in debt.

Notably, the company has lumpy free cash flow with FY2022 and FY2019 ending negative. Here’s a snapshot of the most recent quarters:

Source: Investor Presentation

Supply Chain Issues

According to management, Supermicro’s decline in revenue growth is due to supply chain issues. Per the CFO’s opening remarks:

“Fiscal Q3, 2023 revenues were $1.28 billion, down 5% year-over-year and down 29% quarter-over-quarter, which was below our initial guidance range of $1.42 billion to $1.52 billion. The shortfall was primarily due to key new component shortages for Supermicro’s new generation server platforms which have been mostly resolved to-date.

We note that our shipments against a record backlog may be constrained by supply chain bottlenecks due to high demand for our advanced AI server platforms.”

Supermicro builds complete systems, and the supply chain issues can extend beyond CPUs, GPUs and memory to also include difficulty obtaining metal-oxide-semiconductor field-effect transistors (MOSFETs), diodes and capacitors. If there is low availability with these components, the systems won’t be complete in order to ship. According to The Register, lead times were at 26 weeks back in October compared to the 10-14 weeks that is the target for a healthy supply chain. This is an improvement from 40 weeks a year ago.

Here was another comment on the earnings call:

“These new AI product demands from top-tier companies have led us to challenges in terms of new key components availability.

Compounded with the economic headwind, our Q3 results were reflective of these difficult yet opportune conditions. The good news is that we have already started to address these component shortage pressures over the past few months and we are in a much-improved situation going forward. We have started to produce and ship some back orders since April.”

Risks:

Investors risk entering a frothy AI market. Most tech investors have mastered the extreme exuberance followed by extreme fear that tech seems to oscillate between. We are nearing extreme exuberance on AI with social media exploding over Chat-GPT and Bard. It’s rarely a good sign, and I’m saying that as someone who is exposed to AI-related stocks and benefits from this exuberance. Entering AI stocks right now should be done with a stop in mind.

This company had a short report out earlier this year that caused the stock to selloff. You can read the concerns here.

Regarding fundamentals, the gross margin is the primary concern raised in the earnings calls.

Here was one question from an analyst:

Nehal Chokshi

And what about with respect to gross margin?

David Weigand

Yeah. So, Nehal, we — yeah. Back two years ago, we gave a 17% to 21% — 23% topline growth. Obviously, we’re in there at a minimum of 20%. And for the gross margins, we continue to, like I said, to wrestle with taking market share and also balancing that against gross margins.

But we’re confident with our new manufacturing facilities coming online that we will be able to improve our gross margins. And we also, as we come out of this quarter and we begin to ramp our new product offerings that we will be able to improve margins as well.

Here was another question about the gross margin:

Ananda Baruah:

But I would love to get a better understanding of how you guys are thinking about sort of the gross margin manifestation if we think about the continued layering in of larger footprint, which may come at a slightly lower margin. Is it really that over time, we just expect a greater presence of that lower margin business with some efficiency gains or is it just in the beginning here, the margin will be lower for the new business, but then collectively, the P&L gross margin expands over time?

David Weigand:

Yeah. So we’re looking at it and on — in the — your latter alternative, Ananda, and here’s why. So right now, there’s three things that we’ve been facing. We’re having to face more air transportation costs in order to make our deliveries. So that impacts our margin. And also, we’re having to pay other expedite fees. That impacts our margin.

Number two, we ran a lot less through our factories than in Q3 than we did in Q2. So your margin efficiency, your ability to spread your fixed costs, it’s tremendously impacted on a smaller scale. So as we scale up, we improve our margins.

Thirdly, the — as we ramped our new product offerings, there is an efficiency on these new — on the production of these new products. So we are going to improve the efficiency of these products, which will improve the margin. And so those three things alone speak to margin improvements.

Charles Liang

I can add some color. I mean, as I shared, I mean, we are building a $20 billion of revenue, hopefully in midterm and that’s why a grow our capacity and support a large customer is very important to us. Once our volume becomes higher, our costs will be improved and then business operation efficiency will be higher.

So we are doing better great way to grow our revenue. And so, I mean, once we start to reach that number under $10 billion to $20 billion, I guess, our gross margin will start to grow, because we won’t always invest for big growth after that.

Valuation:

Supermicro has an old school semiconductor top line valuation that reflects its roots as a server maker. Interesting enough, it’s trading at its previous 2015 high. The 5-year median is 0.46 but there’s been too big of a product pivot to rely on this for the future valuation.

On the bottom line, SMCI trades in line with Intel. The bottom line is probably a better gauge for this stock than top line. I took a screenshot with July 2022 marked so you could see where AMD typically trades when it’s not going through a major cyclical event with PCs. It also shows where Intel and SMCI were back in July versus now – about 50% higher valuations.

The 5-year median for SMCI is 15 and has been up to a 20 5-year median in the past.

Conclusion:

The AI market is frothy but we may take a shot at entering. If we stop out, then no big deal. We’d like exposure to Supermicro for its ambitions to overtake the incumbents, plus the clear path the company will take to do so.