Is Super Micro Computer A Buy? Lessons From A Rollercoaster Stock

Dear investor,

Super Micro Computer is a company based in California that makes servers and storage systems for data centers, cloud computing, and artificial intelligence.

In 2023 and early 2024, SMCI's stock price rose sharply. This was mainly because of the growing demand for AI technologies, which increased the need for powerful servers like those made by SMCI. The company also partnered with Nvidia , a leader in AI chips, which boosted its sales and profits.

Their meteoric rise caught the media's attention, creating a positive feedback loop. The more people bought the stock, the higher the price climbed, which attracted even more attention and more buyers, pushing the price up further.

At its peak, the company had a market cap of nearly $60 billion and traded at around $118 per share. Today, its market cap has dropped to $19 billion, with shares trading at about $33 each.

What happened?

In 2023, SMCI’s stock began to falter. The reasons were manifold: renewed scrutiny over its accounting practices, slower-than-expected revenue growth, and an increasingly competitive market landscape. Valuation, once stretched to unsustainable levels, became a key issue.

For smart investors, the story of SMCI offers two vital lessons: the importance of scrutinizing red flags and applying base rates in valuation.

1. Mistake: Ignoring Base Rates

Regression toward the mean is a concept that most investors believe in but few fully understand. The concept says that an outcome that is far from average will be followed by an outcome with an expected value closer to the average.

We see this when looking at the market cap of SMCI at its height. On the 16.02.24 SMCI was valued at around $56 billion - more than $42 billion above the next largest constituent.

Investors who bought at this valuation to “not miss out” made the classic mistake of ignoring the base rate.

Base rates show how similar companies or situations have performed historically, helping to avoid common cognitive biases like overconfidence or extrapolating recent trends too far into the future.

Past performance or market enthusiasm alone shouldn’t drive investment decisions. But base rates provide a statistical perspective. In SMCI’s case, a closer look at the base rates for companies with similar growth trajectories and governance issues might have revealed the risks of overvaluation.

Even when we use the company's historical valuation as a baseline, the discrepancy from the norm is striking:

Yes, a growing company can justify higher valuation multiples, but not to this extreme. At its peak, the stock traded at 92 times its diluted EPS and 76 times its Enterprise Value/EBIT, compared to historical averages of around 19x EPS and 14x Enterprise Value/EBIT.

What outcome were people expecting?

For further reading about base rate investing, consider this article:

2. Mistake: Ignoring Early Red Flags

Super Micro Computer, Inc. has faced several allegations and compliance issues from 2015 through 2024. Below is a chronological overview:

2014–2017: Accounting Violations

Between 2014 and 2017, Super Micro Computer engaged in improper accounting practices. In August 2020, the company settled with the U.S. Securities and Exchange Commission (SEC), agreeing to pay $17.5 million in penalties for these violations.

2018: Nasdaq Delisting

In 2018, Super Micro Computer was temporarily delisted from the Nasdaq Stock Market due to delays in filing financial reports, which were nearly two years late.

2018: Alleged Server Tampering

On October 4, 2018, Bloomberg Businessweek reported that Chinese operatives had allegedly implanted microchips into Super Micro's servers, potentially compromising data security for numerous companies and government agencies. Super Micro and the purported victims, including Apple and Amazon , denied these claims.

August 2024: Hindenburg Research Report

On August 27, 2024, Hindenburg Research released a report accusing Super Micro Computer of ongoing accounting manipulations, undisclosed related-party transactions, and evasion of U.S. export restrictions. The report highlighted the company's rehiring of executives previously implicated in accounting scandals and questioned its governance practices.

August 2024: Delay in Annual Report Filing

Following the Hindenburg report, on August 28, 2024, Super Micro Computer announced a delay in filing its annual report for the fiscal year ending June 30, 2024, to assess the effectiveness of its internal financial controls. This delay led to a significant decline in the company's stock price.

September 2024: Nasdaq Non-Compliance Notice

On September 20, 2024, Super Micro Computer received a non-compliance notice from Nasdaq due to the delayed filing of its annual report. The company was given 60 days to submit a plan to regain compliance.

September 2024: Department of Justice Investigation

In September 2024, the U.S. Department of Justice initiated a preliminary investigation into Super Micro Computer, possibly related to the allegations raised by Hindenburg Research.

October 2024: Auditor Resignation

In October 2024, Ernst & Young (EY), the company's auditing firm, resigned, citing concerns over financial transparency and internal controls. This resignation led to a 33% drop in Super Micro's stock value.

Do I need to say more?

Is this really a stock worth your hard-earned money?

Here’s the kicker: a quick glance at their Wikipedia page could have exposed their troubled history, even before their meteoric rise. No need for a deep dive into SEC filings - a simple look at their Wikipedia entry might have saved many investors.

Corporate governance issues, particularly those related to financial transparency, are significant warning signs. A company’s financial statements are the foundation of valuation. If those foundations are shaky, the whole structure - and the stock price -can come crashing down.

Yet, many investors chose to overlook these signs, lured by the company's impressive revenue growth.

Final Thoughts

1. Don’t Ignore Red Flags: Governance issues, especially accounting allegations, are serious. They undermine trust and can lead to catastrophic outcomes.

2. Focus on Base Rates: Base rates offer a broader perspective. Analyzing how similar companies have performed can help you avoid overvalued stocks and unrealistic expectations.

3. Valuation Matters: No matter how exciting a company’s growth story is, valuation should always be grounded in reality. Overpaying for growth is a common pitfall, and the price of such mistakes can be steep.

Companies with SMCI’s profile - rapid growth coupled with governance concerns - struggle to sustain their valuations. Investors who ignored this lesson found themselves on the losing side when the stock price collapsed.

SMCI’s case of accounting irregularities wasn’t a one-time thing. This is usually a sign of deeper issues.

Instead of dealing with businesses that create problems, it’s smarter to focus on those that don’t - especially with over 100,000 publicly traded companies to choose from worldwide.

Investing is a long game. Let’s play it wisely.

Until the next issue. 🥂

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Disclaimer: This analysis is not advice to buy or sell this or any stock; it is just pointing out an objective observation of unique patterns that developed from my research. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice.

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