Is the “best AI stock” ultra-microcomputer (SMCI.US) undervalued?

In February of this year, KM Capital published a research report giving Chaowei Computer a “Strong Buy” rating with a target price of 885 US dollars. After that, the stock price peaked at more than $1,000 per share, but it turned out to be a strong resistance level. The stock price was unable to stay above this psychological level for a long time, then the stock price fell back and is currently around $820.

In previous analysis, KM Capital highlighted a number of bullish indicators, including strong industry growth, SMCI's superior capitalization of the industry's smooth winds, and strategic partnerships with leading semiconductor companies. While all of these bullish indicators strengthened further in the third fiscal quarter of 2024, the stock saw a further sell-off even after the latest earnings release as investors began to profit from the uncertainty of the sustainability of further growth driven by artificial intelligence.

As an investor who relies only on fundamentals, analysts tend to ignore non-fundamental reasons for stock price movements. In their latest analysis, the analysts described how recent developments have positively impacted all of the fundamental benefits they highlighted in their initial analysis. Furthermore, the latest valuation analysis shows that the stock is still very cheap, and KM Capital reaffirmed SMCI's “Strong Buy” rating.

Fundamental analysis

The financial report for the third fiscal quarter shows that SMCI's growth momentum is very strong. Its revenue has tripled year over year, and adjusted earnings per share have more than tripled. The strong increase in earnings per share was driven by an increase in non-GAAP operating margin, which expanded from 8.7% to 11.3%.

According to the management discussions section of the latest 10-Q report, strong revenue was driven by increased customer demand for GPU servers, high performance computing (HPC), and rack solutions (more complex systems). As a result, the increase in average selling price (ASP) also had a positive impact on revenue growth.

In my opinion, there is also a third important dimension in revenue dynamics, which is classification among different regions. Revenue in all geographic regions showed strong year-over-year growth in the third fiscal quarter, indicating that the AI revolution is a global phenomenon. This suggests that revenue growth is likely to continue for a longer period of time. All of the world's strongest economies are determined to stay ahead in the AI race, which could drive demand for SMCI solutions for a long time.

SMCI's advanced applications require optimized rack solutions, and demand is surging due to advances in generative artificial intelligence technology. Recent reports suggest that demand is expected to remain high for a long time, as several large companies recently announced that they will be investing billions of dollars in data centers using artificial intelligence technology. According to recent news, Amazon (AMZN.US) plans to invest $150 billion in data centers over the next 15 years, which means it will spend an average of $10 billion a year on artificial intelligence infrastructure. According to reports, the second-largest project planned by Microsoft (MSFT.US) and OpenAI will cost an astonishing $100 billion. It is estimated that in 2024 alone, Google (GOOGL.US) will invest up to 9.5 billion US dollars in data centers in the US. As a result, analysts expect demand for SMCI products to remain strong. Of course, SMCI is not alone in this field, and competitors will definitely try to take their place in these projects. However, SMCI's growth rate in recent years has been ahead of the industry, which will allow the company to effectively absorb large data center expenses from tech giants.

SMCI maintains deep collaboration with Nvidia to integrate the most powerful AI chipsets into its server solutions, including the latest news using the Nvidia GH200 Grace Hopper superchip, which SMCI is expected to be an early entrant in this market. Additionally, SMCI has announced a next-generation artificial intelligence solution incorporating the latest Nvidia GB200 Blackwell superchip. In addition to customizing servers based on Nvidia's products, SMCI also works closely with other high performance computing leaders such as AMD (AMD.US) MI300X and Intel (INTC.US) Gaudi AI accelerators.

As a result, SMCI's expectations for the next quarter and fiscal year 2024 are strong. Management placed the midpoint of fourth-quarter revenue expectations at $5.3 billion, which means that the company's fourth-quarter revenue will increase 143% year over year. The median adjusted earnings per share guide for the fourth quarter was $8.02, up 128% year over year and 20% month on month. Throughout the 2024 fiscal year, management expects revenue to reach $14.9 billion, which represents a 109% year-over-year increase.

For fiscal year 2025, the market generally anticipates a 58% increase in revenue and a 42% increase in adjusted earnings per share. This means that SMCI is likely to continue its impressive revenue growth and profit expansion trajectory, which is a strong bullish sign. Analysts pointed out that as big tech companies continue to invest tens of billions of dollars in artificial intelligence infrastructure, this optimism seems reasonable. Among them, J.P. Morgan analysts predict that SMCI's revenue will grow at a compound annual rate of 43% between 2023 and 2027, as the company is expected to occupy up to 15% of the market share in the AI server sector.

As discussed above, there are a number of strong bullish signs supporting SMCI's share price. SMCI operates in a very popular market, and it works with all the biggest semiconductor companies, Nvidia in particular, which has 80% of the GPU market share. Demand for data centers and high-performance chipsets will remain strong given that all tech giants are investing heavily in data centers around the world. SMCI skillfully exploits these favorable trends, and EPS is expanding at a remarkable rate.

Valuation analysis

It's hard to call a stock that has appreciated 500% in value over the past year “cheap,” but discounted cash flow analysis (DCF) shows that it still has solid upside potential. Analysts noted that, according to DCF calculations, the stock was undervalued by 73% after the recent pullback. To calculate upside potential, analysts built a DCF model with a weighted average cost of capital (WACC) of 8.8%. For fiscal year 2024 and fiscal year 2025, depending on Wall Street revenue estimates, forecasting for a longer period of time is always complicated, but as the scale increases, revenue growth of 50% or more is likely to be unsustainable. As a result, analysts expect a sharp deceleration in revenue after 2025. Given the importance of SMCI in the current long-term transformation of artificial intelligence, analysts reaffirm a constant 5% growth rate for sustainable value (“TV”) calculations. Some might say that using a fixed growth rate of 5% is too optimistic because it is several times higher than the average long-term inflation in the US. However, according to Nvidia CEO Hwang In-hoon, he refers to the current artificial intelligence situation as the “iPhone moment”: As shown in the chart below, Apple (AAPL.US) has had a compound annual growth rate of 21% since the iPhone was first released in 2007. In this case, a constant growth rate of 5% seems reasonable.

The company has invested heavily in increasing production to meet demand, so analysts expect a very low free cash flow (FCF) margin of 2% by 2024. However, trends indicate that SMCI has historically been quite successful in turning accrued profits into free cash flow. As a result, analysts expect this indicator to expand rapidly with strong revenue growth, growing 200 basis points per year. According to Seeking Alpha, SMCI has 58.6 million shares outstanding.

After J.P. Morgan announced a 43% compound annual growth rate forecast for the industry from 2024 to 2027, the company is more optimistic about long-term revenue growth prospects, which is mainly beneficial to the increase in stock prices. KM Capital gave a new target price of $1,385, which is a big increase compared to the previous valuation analysis. The fair value obtained at the time was $1,058. KM Capital said it would like to emphasize that its DCF is conservative, and the compound annual growth rate used between 2024 and 2027 was much smaller, at 33%.

In order to cross-check the results of the DCF proposal, SMCI also came to the same conclusion about the valuation ratios of other semiconductor stocks. Although these companies are not direct competitors to SMCI, AMD and Nvidia are also seen as major beneficiaries of artificial intelligence, and these stocks have also shown a strong rebound since early 2023. SMCI is cheaper than Nvidia and AMD in almost all valuation ratios, as shown in the table below. Additionally, I'd like to emphasize that AMD's TTM and FWD revenue growth didn't even come close to SMCI. Therefore, valuation ratio analysis also shows that SMCI is undervalued.

risk factors

SMCI faces intense competition, including well-known technology companies such as Dell (DELL.US), Cisco (CSCO.US), and Hewlett-Packard Enterprise (HPQ.US). As management emphasized in its FY2023 10-K report, most of SMCI's competitors have a longer operating history, greater resources, greater visibility, and deeper market penetration. In other words, SMCI should invest significant resources to maintain its technological advantage, so that it can establish a strong partnership with Nvidia, which dominates the AI chip industry. As SMCI's recent and future financial results show, the company has been very successful in differentiating itself from its competitors, but investors should be aware that the competitive risks are significant.

As recent stock price movements have shown, the stock is extremely volatile and vulnerable to deep sell-offs even without an obvious fundamental reason. The reason is that after the stock price has risen several times since the beginning of 2023, the market is likely to think that the main AI beneficiaries have been overbought on a large scale. As a result, when negative news about the growth or prospects of artificial intelligence comes out, even high-quality businesses like SMCI can be sold off. Analysts pointed out in this regard that it is best to use the dollar averaging method to invest in this highly volatile stock, which provides an opportunity to reduce costs on average in the event of a sharp decline.

conclusions

SMCI is showing unstoppable revenue growth, and its profitability is expanding at an unusually rapid pace. As tech giants continue to increase their investment in data centers, and the company works closely with Nvidia, which is leading the AI revolution in semiconductors, analysts are optimistic about the company's potential for further growth. As a result, KM Capital analysts consider the SMCI rating to be a “strong buy”, especially at current levels, where it has 73% upside potential.