Deep | SMCI: Fundamentals Should Be Approached With Caution

From an Upward Stock Price Super Cycle to a Downward Stock Price Super Cycle

Analyst: Star Z

Some background information about SMCI

Before the end of the year, SMCI had been an enhanced version of NVDA's Alpha, with SMCI's stock price increasing more than tenfold. The main drivers included:

• SMCI's continuous increase in market share for AI servers.

• AI server prices significantly higher than non-AI servers.

• Rush fees for H100 leading to excess profits.

These factors resulted in accelerated revenue growth, rapid margin improvement, and a PE valuation increase from 10x to over 30x. In the report below, we will carefully explain how the above tailwinds will turn into headwinds from now on.

After the beginning of August, SMCI's stock price trend began to diverge from NVDA's. On August 7th, SMCI released its quarterly results, and although revenue exceeded expectations, the gross margin was significantly lower than expected by 3%. The market began to speculate about the impact of intensifying competition on server manufacturers' gross margins and used SMCI and other server manufacturers as short targets to hedge against NVDA's stock price movement.

On August 29th, Hindenburg released a report on SMCI's accounting fraud and related-party transactions but did not directly provide evidence. The next day, SMCI announced a delay in submitting its 10-K report, and the subsequent resignation of its auditor, leading the market to speculate about SMCI's potential delisting and question its authenticity.

As SMCI continued to clarify on various occasions that it would not be delisted, appointed a new auditor, and announced that its Special Committee of the Board of Directors had completed a review of the company's alleged issues without finding any problems, the market began to speculate that SMCI would not be delisted, and the stock price almost returned to the $40-50 range before the delisting concerns.

Although SMCI's delisting is no longer the core trading logic for the company, we believe that the short-selling opportunity based on the company's fundamentals has just begun.

Compared to other OEM/ODM companies in the industry, SMCI has long had an excess gross margin premium. While the industry average gross margin is in the mid-single digits, SMCI has guided that the company can maintain a long-term gross margin of ~14%. When we review SMCI's past history, we realize that this is due to perfect timing and the excess premium brought by its partnership with NVDA.

Where does SMCI's excess profit margin come from?

From the second half of 2023 to mid-2024, the H100 GPU was in a state of supply shortage.

The attitude of the industry's most important player, NVDA, determines the profit distribution of server manufacturers. In NVDA's initial allocation plan, CSPs, Enterprise, and Sovereign AI were allocated in roughly equal proportions. Compared to CSPs, which have complete IDC construction and maintenance capabilities, Enterprise and Sovereign AI have never maintained such complex systems as H100 GPU servers in the CPU era.

Therefore, manufacturers like SMCI that can provide system services are crucial. At the same time, SMCI prepared and responded very early and was one of the first OEM manufacturers to have H100 servers ready. Even for the most capable CSPs, they could not find a suitable ODM manufacturer to build servers. This allowed SMCI to not only take the share of Enterprise and Sovereign AI but also the early share of CSPs.

This also made NVDA very appreciative of SMCI's work and gave SMCI great support in allocating servers. SMCI, through its close relationship with NVDA and early preparation for the industry, earned a premium in a supply-constrained environment.

In many customer surveys, we even observed that due to SMCI's unique advantage during this one-year period, SMCI could even charge rush fees, with the rush fees reaching up to a 30% premium on the original price of the server.

However, as the supply and demand of H100 balanced out and market competition intensified, SMCI's market position changed

The attitude of CSPs is crucial in this process. ODM manufacturers, through long-term learning, have gradually developed the ability to serve the GPU server needs of CSPs.

Therefore, CSPs began to introduce ODM manufacturers, including Dell and HPE, which had previously served CSPs. During the process of introducing ODMs, H100 server prices continued to fall, and discounts for large customers also increased.

This price competition became more and more intense as ODMs continued to enter the market:

• Taiwanese ODMs entering the industry, led by Inventec, quoted prices of $230,000 to $240,000 per server, implying a gross margin of less than 5%.

• DELL, HPE, and others also won customers with lower quotes than SMCI, and they have better relationships with CSPs.

• SMCI has been communicating with customers that its H100 servers have a lower failure rate and deserve a higher premium, but even with a 10% premium, the current pricing has to be reduced to $250,000 to $260,000 due to competitors' lower prices, implying a gross margin of 5-7%, far below the company's 14% gross margin guidance.

However, during the excess profit margin phase, SMCI could achieve a gross margin of over 15% because of the lack of competition. SMCI's current server gross margin has already experienced a huge decline.

This competition exists not only in prices but also in payment methods. In our May survey of Lambda, Coreweave, and other companies, we found that these GPU CSPs purchase servers through collateralized loans with an annualized interest rate of 11-14%. As Dell, HPE, and other ODMs with ample cash flow joined the market, they also won these capital-constrained CSP customers with annualized interest rates below 10%.

The company hopes that the short-term high gross margin of H200 can make up for the gap, but our survey shows that this is also very difficult:

• The supply of H200 is very limited, and the peak shipment period may only last for 2-3 quarters, still being NVDA's transitional product.

• Customers, including SMCI's super-large customer TSLA, may also adopt more B-series GPUs in new bids at the end of 2024, skipping H200.

• Even if H200 supply is obtained, its price is not much higher than H100. The actual survey shows that the shipping price is $260,000 to $270,000, with a gross margin of only 7-8%.

After the H-series GPUs enter the B-series GPUs, SMCI's market position will be further weakened

In the GB-series GPU server design process, NVDA provides a very complete and complex manual. NVDA defines each SKU, including the type of metal plate to be used, which is clearly defined.

In the past server design process, OEM manufacturers represented by SMCI had independent design capabilities. SMCI claims to have over 1,000+ SKUs and corresponding suppliers, which have increased its bargaining power.

But in the GB series, everything has to follow NVDA's arrangement. GB-series GPU servers have changed from a design product to a standard product, and all OEM/ODMs need to follow NV's design manual, making it difficult for manufacturers to differentiate.

Although CSPs may still have customization needs and find ODMs for additional customization, more customers will tend to purchase standard products designed by NVDA.

This change will further reduce the added value and gross margin of GB-series GPU servers. It also makes OEM manufacturers represented by SMCI almost indistinguishable from ODM manufacturers represented by Inventec, Quanta, and Wistron in the production of GB-series servers. Even some suppliers who previously made graphics cards and SATS have started to make AI servers.

Taiwanese ODM server manufacturers have always been price killers in the industry. Their products will maintain the pricing habit of 5-6% gross margin as in the past, and their production capacity is extremely large, which can easily change the pricing model of the entire server industry. We find it hard to believe that SMCI can still have an 8-9% price premium over these Taiwanese ODMs when the overall design has not changed much.

GB-series GPU servers may account for 70% of the CY2025 B-series GPU server market, with the remaining being B200 and other servers.

For B200 servers, SMCI may still maintain a higher gross margin because it does not need to follow the strict design manual of the GB series.

However, based on current customer demand feedback, B200, like H200, is also a transitional product:

• With the adoption of more complex models such as O1, customers also need larger racks to support inference and training needs.

• NVDA, as the dominant player, is also more inclined to produce GB200 instead of B200. From an allocation logic perspective, NVDA is also unwilling to allocate B200.

• Customers willing to allocate, such as AWS, need B200 servers due to their own CPU needs, but SMCI can hardly enter AWS's supply chain. AWS procures more through ODM manufacturers such as Wiwynn.

This also makes it difficult for the only remaining hope, H200 servers, to support SMCI's gross margin expectations.

Recent negative news about fraud and auditing has further prompted SMCI customers to switch orders

The server industry is a very capital flow-dependent industry, requiring manufacturers to advance funds for customers. If the turnover is once every three months, server manufacturers like SMCI need to advance funds 3-4 times, and the demand for capital turnover is very large.

For example, in GB-series servers, server manufacturers need to purchase Compute Tray and Switch Tray from NVDA, which account for more than 90% of the total cost, and sell them to CSPs after assembly to recognize revenue.

Also because of this, Taiwanese ODMs such as Foxconn and Quanta have seen a significant deterioration in free cash flow, mainly due to component inventory and capital expenditure.

As a customer, they will be very concerned about:

• Problems with the company leading to a slowdown in cash flow turnover or even a broken capital chain.

• Difficulty in bank credit. In the 8-K filing submitted by SMCI on November 26, SMCI mentioned, "On November 20, 2024, Super Micro Computer, Inc., prepaid in full and terminated its obligations under each of the Loan Agreement, by and among the Company and Cathay Bank, as amended or otherwise modified, and the Loan and Security Agreement with Bank of America N.A., by and among the Company, the lenders party thereto, and Bank of America N.A., as administrative agent, as amended or otherwise modified."

• Loss of sales and technical personnel.

If the cash turnover cycle changes from 3-4 times a year to 5-6 times, it will inevitably lead to a decline in revenue. The above also shows that the impact of fraud and auditing goes far beyond the company's reputation and can have a significant impact on customer delivery.

This makes it easy to understand why NVDA has come out to firmly support SMCI, stating that its business has no problems. If SMCI really experiences a broken capital chain, it will also have a major impact on NVDA.

We have indeed seen quite a few order switches:

• Coreweave switched orders to DELL, Wiwynn, and GIGABYTE.

• YTL switched a $1 billion order to Wiwynn.

• TSLA and XAI are considering switching orders to Inventec, Quanta, and Foxconn.

• AAPL is considering switching orders to Foxconn, Wiwynn, and Inventec.

• KKDI terminated its partnership with SMCI.

Figure. KKDI terminated its partnership with SMCI

Liquid cooling is unlikely to make a contribution in the first half of next year

SMCI mentioned that liquid cooling could increase its server product by 3-4%, and according to the company, its gross margin could reach over 17%.

However, liquid cooling delivery is still a big challenge in the first half of next year, as most IDCs still do not have liquid cooling delivery conditions. If it is delayed to the second half of next year, the liquid cooling advantage mentioned by SMCI will be caught up by other ODM manufacturers.

Liquid cooling manufacturers with a Chinese background, such as Inventec, have also entered the liquid cooling testing process, and the choice of suppliers may not be scarce.

Stock price is driven more by index ETFs and retail investors, making it difficult for institutions to buy

SMCI still has not issued its 10-K filing and is unwilling to disclose the reason. Most long-only and hedge funds are unable to buy SMCI stock due to compliance requirements.

Its stock price relies more on the capital inflow brought by index ETFs. The enthusiasm of retail investors to bottom-fish SMCI has also led to a significant rebound in SMCI's stock price after the temporary easing of delisting concerns.

Considering that there are no real institutional buyers, it is very easy for SMCI to have a very strong stock price reaction due to being removed from the index. If SMCI is removed from the Nasdaq 100 index today, it will further increase the risk of being removed from the S&P index.

Perfect Time to Short Again

After this rebound, SMCI's stock price has not priced in the delisting risk. Considering the intensifying future competitive landscape and the risk of customer order switching, now is the perfect time to short.

2023 and the first half of 2024 were SMCI's super cycle of market share increase, ASP increase, rapid revenue acceleration, margin improvement, and ultimately a re-rating of valuation from 10x PE to as high as 35x PE.

But from now on, all the previous positives will reverse into negatives, ushering in a downward super cycle for SMCI with market share decline, ASP decline, quarter-on-quarter revenue decline, margin decline, and ultimately a continuous de-rating of valuation.

Based on our Base Case (50% probability):

• Assumption: Existing orders do not switch, but new orders such as Coreweave will switch.

• CY2025 EPS = $1.5, current stock price corresponding to 25x PE

• Based on the ODM industry's 10-15x PE valuation range, the stock price will fall to $15-23, with an average decline of 50%.

Based on our Bear Case (30% probability):

• Assumption: Existing orders also switch, including super large orders such as TSLA and XAI.

• CY2025 EPS = $1, current stock price corresponding to 38x PE

• Based on the ODM industry's 10-15x PE valuation range, the stock price will fall to $10-15, with an average decline of 70%.

Based on our Bull Case (20% probability):

• Assumption: No significant order switching occurs, but margin erosion due to intensifying competition still exists.

• CY2025 EPS = $2, current stock price corresponding to 19x PE

• Based on the ODM industry's 10-15x PE valuation range, the stock price will fall to $20-30, with an average decline of 35%.

Considering the probability-weighted target price, $19 * 50% + $12.5 * 30% + $25 * 20% = $18.

SMCI still has a chance to be cut in half, and the narrative and actual survey situation are very much in line.

Finally, here is a chart showing the market share changes in the AI server industry.