Why Investors Should Look Past the Noise in SMART Global Holdings' Q1 Earnings Report

SMART Global Holdings (SGH -3.43%) tumbled on its first-quarter earnings report on Jan. 4, and the stock has continued to slide since then.

Like many manufacturers, the company has faced supply chain challenges and is spending to ramp up production. In this episode of "Beat and Raise," recorded on Jan. 20, Fool contributors Brian Withers and Ryan Henderson discuss why this tech stock may be being excessively punished for investing in the business.

Brian Withers: Ryan, you're going to kick us off with SMART Global Holdings, and maybe you could just give folks a little overview on what the heck this company does because I don't know that a lot of people know this company.

Ryan Henderson: Yeah. I didn't know going into it. But it took me a few times but I was able to research it and get some understanding for the business. SMART Global Holdings, or SGH. It's a diverse set of businesses that's been molded through acquisitions, and so they design and manufacture specialty solutions for computing memory and the LED markets, and so that's the three reporting segments that are under their umbrella. So that's memory solutions and then intelligent platform solutions, which has a few different segments within it and they call that IPS, and then the LED solutions. Do you want me to pull up the slides?

Withers: Yeah. Why don't you go ahead and pull up the slides? Yeah, I was interesting. I was reading through and I'm going intelligent solutions, AI, high-performance computing, and then memory, and then LEDs? What? [laughs] Yeah, so this company has been built through acquisition and they seem to be pretty good at it.

Henderson: Let me pull it up make sure you can see it. Can you see that?

Withers: Yeah. There it is, beautiful.

Henderson: They did report as you said, I guess I want to say two weeks ago now.

Withers: Yeah.

Henderson: The initial reaction wasn't great and I'll get into why that is. But in terms of just top-line numbers, Q1 revenue, I think it was within their range, but it was at the high end of their range so just top-line, that was good to see. Their earnings-per-share missed but that was on a GAAP basis. With the recent Cree LED acquisition, which is what it's called, they're recognizing a lot of non-cash charges which are required in GAAP accounting. There's a big discrepancy right now between non-GAAP earnings and GAAP earnings, so non-GAAP earning was in line with their estimates but GAAP was just a little bit off. Then their outlook for next quarter was sales growth from 37% to 50%. But that's inclusive of the Cree LED acquisition, so organically, it'll be a little bit lower, and that seemed to be right in the ballpark of where I think analysts wanted it.

A few headlines from the quarter were the supply chain constraints. I guess that's probably been a theme for anyone that deals in the physical world these recent few quarters. But there's a quote from the CEO and he talked about it and he says that and if you go in and you look at the cash flow statement, in their reconciliation from net income to cash flow, there's a lot of working capital adjustments. In order to meet end demand, they are pouring a lot of money into that working capital, bolstering inventory, and so their cash flow looks far lower and I think the worry from investors is, how long is that going to last? Is that going to be ongoing? Is that going to be a problem that persists for the coming quarters? I think that was a large part of the reaction post-earnings, as you can see, it had a quick drop, I guess, following it.

Other things they did report really, year over the year, they reported really good strength in their IPS. I think I'm getting that right. Yeah, the IPS segment. This is the part that they acquired a company where in 2018, it was Penguin Computing and Penguin Edge. Those are the two companies and that's basically high-tech solutions, so AI machine learning for end-to-end stuff. It's hardware, software, and then managed services for government customers, energy, the education sector. A lot of that ends up being lumpy with the billing period. The CEO actually talked about this, which was expect quarter-to-quarter variability. Their revenue was up, I think 80% this year or this quarter year-over-year. But he said expect quarter-to-quarter variability because so much gets recognized at once because they're bigger projects. If you've got hardware being recognized and the managed services being recognized, and it just falls in Q1 and instead of Q2, you're going to have some variability there. I just recommend looking at the trailing 12-month numbers for that.

Withers: I noticed the Penguin Computing stuff IPS, which is their fastest-growing unit, actually has some software as well, but it's only like 17% of the business. To your point, as these projects execute and get rolled out, I don't know that you're going to see an 80% year-over-year gain every quarter in that segment.

Henderson: Right. I don't completely understand the Penguin Computing business, I think you have to be a technical expert to completely understand it. But the CEO made it sound like it's very complex, and so it becomes very hands-on and it's not, you can't just sell the software and just leave them alone. The managed services is a component of that. But as you said, there's definitely the software revenue as well.

The concerns. I think the biggest one. Well, I guess I should mention the two-for-one share split. I always find it funny when companies split their shares just because it's a smaller slice of the same pie. But they did mention that they think that it will bring liquidity or maybe a larger shareholder base.

If that happens, that's great for them and they are able to get more shareholders. That's awesome. It will, however, nominally earnings-per-share will look lower. That's not going to happen in Q2, but it should happen eventually, I think, in Q3. If you see this big drop nominally in earnings-per-share, don't be shocked. That's just because there are smaller shares.

All-in-all, I hope their quarter was fine. The supply chain stuff, and it seems to be a theme with every business I've looked at lately is, how long is it going to last? How much is it going to impact cash flow? If this is temporary, that's great, hopefully, they can swallow that cost for a quarter or two and move on and get past it. But you don't want a whole bunch of money tied up in inventory. Hopefully, you get more cash flow into the business. Am I missing anything or did that cover most of the quarter?

Withers: No. I think this is the first time we've shared this stock on the "Beat and Raise" show. It's a recent rec and it's an interesting tech play both in its into services, it's into professional management services, data management services. It's got some consulting arm, it's got some hardware, and it's got some software stuff. It's a pretty diverse business and being a small market cap, it's for those that are interested in smaller market cap tech plays. This is one you might consider. I really appreciate your covering this one, Ryan. There was a bit of a drop after earnings, but the whole market has gone down, so I don't know that we should attribute anything specifically to negative attention on SGH.