Server and storage system manufacturer Super Micro Computer (SMCI 8.89%) has gone from an under-followed value stock to a top pick among investors looking to bet on artificial intelligence (AI). 2023 was an excellent year: The stock soared nearly 250% higher.
By all indications, Super Micro could still be a great value right now. But I'm passing once again on this data center and enterprise compute manufacturer. Here are three reasons why.
1. Super Micro is sitting on a massive opportunity, but so is everyone else
Super Micro's head of steam has been building thanks to generative AI. Chip companies like Nvidia (NVDA 6.18%), AMD (AMD 2.37%), and Intel (INTC -9.20%) have been tapping the manufacturer to assemble servers (a powerful computer that gets installed in a data center or business office) that power AI applications. It's also getting in on the Arm Holdings data center server game and has a new lineup of servers using chip design start-up Ampere Computing Arm-based chips.
Super Micro just upgraded its revenue guidance for 2024, with expectations for it to be in a range between $10 billion and $11 billion -- versus $9.5 billion to $10.5 billion before. The dramatic rise thanks to AI is especially clear when viewing sales over the last five years. Super Micro was hauling in only a few billion dollars in revenue just three years ago.
Data by YCharts.
However, Super Micro competes against many other companies that design and assemble servers and storage devices on behalf of its semiconductor design and manufacturing partners. Competitors include Cisco Systems, Dell Technologies, Hewlett Packard Enterprise, and a growing presence in the server market from equipment and design manufacturers in Asia like Foxconn and Inspur.
All these peers are also sitting on a massive generative AI opportunity. Super Micro is clearly a standout as it has gone from a small and relatively unknown company to a hot stock riding the AI wave. But I can't ignore the hotly competitive field that Super Micro battles in.
2. It's all about forward earnings growth, but not Super Micro's own growth
At this point, given the sustained growth Super Micro is expecting, many investors are drawn to the cheap valuation -- especially when comparing it to the premium price chip stocks like Nvidia and AMD are fetching these days.
Indeed, Super Micro could be a great long-term value right now. Shares trade for 26 times trailing 12-month earnings per share (EPS), but only 16 times expected EPS for fiscal 2024. That compares to the respective 24 and 27 times expected EPS for Nvidia and AMD for next year.
Data by YCharts.
However, Super Micro's growth is not coming from its own efforts. Rather, it's riding the coattails of others, primarily leaders in semiconductor design, as it makes hay from the AI movement. No matter how you slice it, Super Micro is dependent on ultimate sales of AI servers powered by partners like Nvidia and AMD, making it a type of derivative bet on those businesses' performance. That's a big reason for the relative discount on Super Micro stock.
3. Super Micro admits it has some key disadvantages
Nevertheless, Super Micro is raking in the chips thanks to AI, and its stock is a relative value. So why not just buy?
For me, it's all about the business model. Super Micro is not in full control of its own destiny. It could be very cheap if growth
continues, but that growth and resulting profitability will be dependent on chip design partners Nvidia, AMD, and the like -- and less on Super Micro's own execution. Again, by Super Micro's own admission in its financial filings, it has limited ability to stave off competitors over the long term. In the last annual filing, Super Micro said the following (italics inserted by me):
We seek to protect our intellectual property rights with a combination of patents, trademarks, copyrights, trade secret laws, and disclosure restrictions. We rely primarily on trade secrets, technical know-how, and other unpatented proprietary information relating to our design and product development activities.
In other words, the majority of Super Micro's work has no patent protection, which is a key item I look for when investing in hardware-based businesses (like semiconductor stocks). Although Super Micro certainly has its own proprietary way of designing and assembling enterprise computing and storage systems, few of those processes are granted patent and intellectual property (IP) protection. Again, by Super Micro's own admission in its last annual filing:
Our industry is marked by a large number of patents, copyrights, trade secrets and trademarks and by frequent litigation based on allegations of infringement or other violation of intellectual property rights. Our primary competitors have substantially greater numbers of issued patents than we have which may position us less favorably in the event of any claims or litigation with them. Other third parties have in the past sent us correspondence regarding their intellectual property or filed claims that our products infringe or violate third parties' intellectual property rights. In addition, increasingly non-operating companies are purchasing patents and bringing claims against technology companies. We have been subject to several such claims and may be subject to such claims in the future.
When looking for a long-term investment in AI, and in whatever other mega trends lie ahead for the greater IT sector, I can't say "yes" to owning every stock. This kind of risk and lack of competitive differentiation inherent in Super Micro's business model just doesn't cut it for me. Besides, I already own ample shares of Nvidia, AMD, and data center design leader Arista Networks, so buying Super Micro would offer little in the form of portfolio diversification for me.
I understand the draw to Super Micro stock as 2024 gets underway, and the swarm of investors betting on the company could be right in assuming it will be a big beneficiary from the AI movement. But as for me, I'm passing on Super Micro stock again in 2024.
