SMCI - An Intriguing Story

Revelations from SMCI's financial reports.

Super Micro Computer, Inc. (SMCI), a manufacturer of high-performance server and storage solutions, caught the fancy of investors in June 2022. SMCI was trading in the mid-30s and had been languishing in that range for years. Slowly, earnings started to perk up amid the AI hype slowly building up. But were there telltale signs that earnings for 2022 were going to be stellar? If only one were to pay attention to what the CEO had to say in the 2021 Annual Report. (Note: For financial reporting purposes, SMCI’s fiscal year runs from July to June.) Here are some excerpts from Charles Liang’s, Chairman & CEO of SMCI, letter to the shareholders in the 2021 Annual Report.

My optimism for our future is being fueled by the myriad of new computing demands driven by a broad array of new applications across AI, 5G, Edge, Telco, Cloud, and Storage platforms.

My confidence in our ambitious long-term vision and strategy of achieving $10 billion in annual sales along with increased profitability over the next 3-5 years is stronger and appears to be happening faster than it was planned.

Charles Liang, Chairman & CEO of SMCI

I would not hold it against you if you said the shareholder letter is all fluff and management tries to tout up their business in those. Mostly true. However, sometimes CEOs do share their strategy and will highlight some nuanced or direct events and actions that will go on to impact the company for the next few years or more. Such was the case of SMCI and the believers have been rewarded. A stock that was languishing in the low 30s and high 20s is now trading at around 875.

However, it was not until mid-2022 that the Street woke up and took notice. Earnings were stellar and Liang’s commentary got even more bullish. (Excerpts from the 2022 Annual Report.)

Thirty years ago, we grew from a small garage into a $5.2 billion revenue company, in fact, our growth accelerated in FY 2022, hitting a rate of 46% year over year.

We see our product lineup for new GPU and CPU solutions accelerating which has made Supermicro one of the fastest-growing IT companies in the US last year, continuing to support our mid-term goal of $20 billion in revenue.

Charles Liang, Chairman & CEO of SMCI

So, in 2021, Liang was talking about achieving $10 billion in revenues in 3 to 5 years, and in 2022 upped the ante and increased the target to $20 billion. Wall Street took notice and the bull run started.

The primary driver for this sudden change in fortunes was the incessant demand for Nvidia GPUs, and as it so happened, SMCI was at the forefront of providing server solutions for Nvidia GPUs. It essentially rode Nvidia’s coattails and in 2024 became a sort of meme stock, zooming approximately 300% in the first three months.

While SMCI doesn’t explicitly highlight how much of its revenue is due to Nvidia, we can try to make a subjective guess. In the quarter ended March 31, 2024, their largest supplier (identified as “Supplier A”) accounted for 69.8% of its total purchases. (Refer: Q3 2024 Form 10-Q page 8, pdf page 11). I will be using this convention for citing references from the Annual Reports, and 10Qs so that you can easily find the page in the pdf. Moving on, so “Supplier A” has to be Nvidia, right? I don’t know, but if I were to take a guess, absolutely yes.

All fine and dandy. Great job Mr. Liang. However, the server and storage business is cyclical in nature. It is not as if a company is going to keep spending billions of dollars to upgrade its data center every year. Ongoing maintenance and small improvements, yes, major upgrades, no.

Once the CAPEX is done unless there are compelling reasons that would enhance growth or increase profitability, further CAPEX will have to wait. For an analogy, look no further than IBM’s mainframes. While it is not a like-for-like comparison, it should give one an idea about what I am talking about.

To further appreciate this reality, look no further than Amazon’s recent announcement about Nvidia GPUs after reports in the media suggested that Amazon had halted orders.

To be clear, AWS did not halt any orders from Nvidia. In our close collaboration with Nvidia, we jointly decided to move Project Ceiba from Hopper to Blackwell GPUs, which offer a leap forward in performance.

AWS continues to offer other services based on Nvidia's Hopper chips, its flagship model for training artificial intelligence systems (AI).

Amazon Spokesperson

I would request you to pause and read between the lines. Again, this is subjective. So, Amazon has not halted any old orders but is not giving out any new orders for Hopper GPUs. Do you expect Amazon to throw away all the Hopper-based systems next year and move to Blackwell GPUs? The rational answer would be, no.

Given this background, let’s circle back to SMCI. However, before I embark on providing my insights, I would like to get a few things out of the way.

1. Neither I nor anyone associated with me or Orca Fin has any positions in SMCI or NVDA.

2. As per Orca Fin’s internal governance policies, related parties of Orca Fin can only take new positions in SMCI or NVDA 30 days after this article is published.

3. Some of the inferences here will be subjective and the reader has the right to completely disagree with me. It is just my opinion and inferences, and nothing beyond that. Hence, use your judgment or consult a certified financial advisor before arriving at any conclusions.

Interest Piqued

After market hours on February 21, 2024, fintwit, the finance community on X, was waiting for Nvidia to release its quarterly and full-year results for the period ending 12/31/2023. One thread, that was getting quite a lot of interaction was about fraud in Nvidia. I joined the party and suggested that people run the Beneish M-Score on Nvidia.

Nvidia’s results came out and out came the fanboys after me; asking me whether I had run the test, what the result was, and the usual abuse as if I was their mortal enemy. I got so sick of them that I ran the test in disgust just to make them go away. It takes all of five minutes to run and they couldn’t run it themselves? What I was not expecting was for Nvidia to fail the test. My interest was piqued.

I went on to run the test on SMCI and TSLA. Both failed. Spicey. I wrote about this after exchanging a few emails with Dr. Beneish, Professor of Accounting at Kelley School of Business, Indiana University.

Dr. Beneish was concerned about TSLA and SMCI and specifically asked to investigate their deteriorating gross margins. Thus, the journey began to unravel what could possibly be going on with these companies.

As a side note: as a retail investor, if a company fails the Beneish M-Score with an assessment of “Likely Manipulator”, walk away from the stock. There are better things to do in life. However, in this article, I will attempt to show you the good, the bad, and the ugly about SMCI.

Management

While the Beneish M-Score clearly indicates shenanigans are going on with the financial books, without proof it would be foolhardy to make such allegations. However, the character of a person does get tarnished if there is a court judgment (ruling) against them.

On February 8, 2018, two punitive class action complaints were filed against SMCI, the CEO (Charles Liang) and its former CFO. The allegations? Misrepresentation and/or commissions in public statements regarding recognition of revenue. (Refer: 2023 Annual Report page 97, pdf page 106). Long story short, here is the final outcome (quoted from the same page in the Annual Report).

The Court denied the motions to dismiss the Section 10(b) and Section 20 claims against the Company, Charles Liang, and Howard Hideshima, the Company’s former CFO. On March 11, 2022, the Company, together with the individual defendants, agreed in principle with plaintiff’s counsel to settle the action. On April 8, 2022, the parties entered into a stipulation of settlement, pursuant to which and subject to Court approval, plaintiff will dismiss with prejudice and release on behalf of a class of shareholders all claims against defendants, including the Company, in exchange for payment of $18,250,000, of which sum $2,000,000 will be funded by the Company……

Following the Court granting preliminary approval, settlement funds were transferred into an account controlled by the settlement’s escrow agent to be held until the Court granted final approval. Following the May 4, 2023 hearing, the Court granted final approval in a subsequent order issued on May 5, 2023, which fully resolved the action.

So, Beneish M-Score flags SMCI, and its current CEO was fined for cooking books previously. You see where this is going? Red flag, right? Is “stuff” going on now? I don’t know. However, as you will see, there are enough red flags in the recent regulatory fillings.

Differential Disclosures

Since we are discussing the management’s trust factor, I will highlight one instance of differential disclosure here. As you read along, you shall see examples of a few more.

Refer to the “Corporate Strategy” section (pdf page 4, 2023 Annual Report).

….. nearly all our server and storage systems are manufactured and tested in-house either in Silicon Valley, Taiwan, or the Netherlands, giving us a synergistic and global supply chain advantage that complements our design expertise.

Super Micro Computer, Inc.

Not true. Critical components such as server chassis and power supplies are manufactured by related party vendors. Based on what SMCI has disclosed about its real estate, it seems they share office/manufacturing space with these vendors. If one were to do a play on words, SMCI is actually not lying. More on this in the “Related Parties” section.

So, they claim one thing on the fourth page of the glossy parts for the shareholders and hide the gory details in the footnotes. Another red flag for you.

A few related thoughts:

• Deloitte is out as SMCI’s auditor. EY is in for this financial year ending July 31, 2024. (Refer: 2023 Annual Report page 97, pdf page 106). Deloitte had been SMCI’s auditor from 2003 till 2023. Since we don’t know the facts behind the change, it is best to keep it to the fact that auditors have changed.

• Charles Liang must have been in deep doo-doo financially in 2018. Reproduced from the 2023 Annual Report, page 140 under the “Loans” subsection. (pdf page 149)

In October 2018, our Chief Executive Officer, Charles Liang, personally borrowed approximately $12.9 million from Chien-Tsun Chang, the spouse of Steve Liang. The loan is unsecured, has no maturity date and bore interest at 0.8% per month for the first six months, increased to 0.85% per month through February 28, 2020, and reduced to 0.25% effective March 1, 2020. The loan was originally made at Mr. Liang's request to provide funds to repay margin loans to two financial institutions, which loans had been secured by shares of our common stock that he held. The lenders called the loans in October 2018, following the suspension of our common stock from trading on NASDAQ in August 2018 and the decline in the market price of our common stock in October 2018. As of June 30, 2023, the amount due on the unsecured loan (including principal and accrued interest) was approximately $16.0 million.

Inquiring minds want to know why this personal loan is still outstanding. However, it is a family and a personal matter. Hence, it is not material for shareholders as such given the amount in the context of Liang’s compensation (Salary: $421,785; Option Awards: $11,616,000; Non-Equity Incentive Plab Compensation: $6,057,526; Total: 18,098,671). But why?

What skeletons do thou hide in thy closet, Mr. Liang?

Related Parties

If one were to cursorily look at the board and the executive team, everything seems fine as far as related party involvement. Husband (Charles Liang, Chairman & CEO) and wife (Sara Liu, co-founder), founder and co-founder, each own 14.5% of the company, and the rest of the team have no personal relations with them.

For most, that would be sufficient, but things are spicier than they appear on the surface. Turn to page 138 of the 2023 Annual Report (pdf page 147) if you are following along.

Family Members Employed with SMCI

• Hung-Fan (Albert) Liu, brother of Sara Liu, is employed with SMCI in San Jose, California. Compensation: $557,452 in fiscal year 2023.

• Shao Fen (Carly) Kao, sister-in-law of Sara Liu, is employed with SMCI in their information systems organization in San Jose, California. Compensation: $321,944 in fiscal year 2023.

• Mien-Hsia (Michelle) Hung, the sister-in-law of Sara Liu, is employed with SMCI in their marketing organization in Taiwan. Compensation: $139,953 in fiscal year 2023.

Nothing wrong with having a few family members employed in the company one co-founded. Absolutely nothing untoward with this and most certainly doesn’t seem like a family fiefdom on the surface. But as I dug around on, it does seem to be one.

Ablecom and Compuware

You will love this. This thing would seem like it is right out of a fiction novel. (Refer: 2023 Annual Report page 138, pdf page 147).

We have entered into a series of agreements with Ablecom Technology Inc. ("Ablecom"), a Taiwan corporation, and one of its affiliates, Compuware Technology, Inc ("Compuware"). Ablecom’s ownership of Compuware is below 50% but Compuware remains a related party as Ablecom still has significant influence over the operations.

So, two of SMCI’s vendors are related parties to each other and of SMCI. Intrigued minds would want to know if there is any material impact. Financially material, operationally significantly material. (Refer: 2023 Annual Report page 42, pdf page 51).

Our purchases of products from Ablecom and Compuware combined represented 6.6%, 8.3% and 7.8% of our cost of sales for fiscal years 2023, 2022 and 2021, respectively.

Here are the financial impacts of Ablecom and Compuware in more detail. (Refer: 2023 Annual Report page 139, pdf page 148, emphasis added for clarity).

Ablecom’s sales to us comprise a substantial majority of Ablecom’s net sales. For fiscal years ended June 30, 2023, 2022 and 2021, we purchased products from Ablecom totaling $167.8 million, $192.4 million and $122.2 million, respectively. Amounts owed to Ablecom by us as of June 30, 2023, 2022 and 2021, were $36.9 million, $46.0 million and $41.2 million, respectively. For the fiscal years ended June 30, 2023, 2022 and 2021, we paid Ablecom $12.1 million, $8.3 million and $8.6 million, respectively, for design services, tooling assets and miscellaneous costs.

(this is for SMCI’s finished products) Compuware’s sales of our products to others comprise a majority of Compuware’s net sales. For fiscal years ended June 30, 2023, 2022 and 2021, we sold products to Compuware totaling $36.3 million, $26.1 million and $27.9 million, respectively. Amounts owed to us by Compuware as of June 30, 2023, 2022 and 2021, were $24.9 million, $19.6 million and $18.2 million, respectively. The price at which Compuware purchases the products from us is at a discount from our standard price for purchasers who purchase specified volumes from us. In exchange for this discount, Compuware assumes the responsibility to install our products at the site of the end customer and administers first-level customer support.

(this is for manufacturing of components, mostly power supplies) For the fiscal years ended June 30, 2023, 2022 and 2021, we purchased products from Compuware totaling $217.0 million, $170.3 million and $113.4 million, respectively. Amounts we owed to Compuware as of June 30, 2023, 2022 and 2021 were $66.2 million, $60.0 million and $46.4 million, respectively. For the fiscal years ended June 30, 2023, 2022 and 2021, we paid Compuware $2.0 million, $1.5 million and $1.8 million, respectively, for design services, tooling assets and miscellaneous costs.

First off, as far as reporting is concerned, everything looks in order and properly disclosed and reconciled (Refer: 2023 Annual Report page 85, pdf page 94). The outstanding amounts in the context of the inter-party transactions do raise an eyebrow, but in the context of the overall scheme of things, financially it doesn’t seem to be an issue but it can swing “adjusted EPS” by a few pennies or more.

Also, it wouldn’t be irrational to wonder if such a structure could be used for revenue and/or expense manipulation, and/or channel stuffing. Again, I have no evidence of any of that happening. Hence, file it under, “It is just a thought and good to know.”

However are there any issues with Accounts Receivables and Accounts Payable due to these related party transactions?

No issues here. Also, accrued liabilities due to related parties have grown from $14.0 million on June 30, 2023, to $18.8 million on March 31, 2024. Immaterial. Overall Days Sales Outstanding for all of SMCI’s Accounts Receivables is well within its 30-60 day contract payment terms. Nothing to see here. All good.

Alright. Round-tripping is going on but not in an illegal way, so it seems based on the disclosures. But what is the impact or risk operationally and what is all this round-tripping about? (Refer: 2023 Annual Report page 138-139, pdf page 147-148. Emphasis added for clarity).

We have entered into a series of agreements with Ablecom, including multiple product development, production and service agreements, product manufacturing agreements, manufacturing services agreements and lease agreements for warehouse space.

Under these agreements, we outsource a portion of our design activities and a significant part of our server chassis manufacturing and chasis components to Ablecom. Ablecom agrees to design products according to our specifications. Additionally, Ablecom agrees to build the tools needed to manufacture the products. We have agreed to pay for the cost of chassis and related product tooling and engineering services and will pay for those items when the work has been completed.

Lots of moving parts implying lots of avenues to tinker around with. However, the important part, operationally, here is the server chassis manufacturing part. What is SMCI’s exposure to Ablecom for this? (Refer: 2023 Annual Report page 83, pdf page 92).

Ablecom manufactured approximately 91.9%, 88.2% and 91.8% of the chassis included in the products sold by the Company during fiscal years 2023, 2022 and 2021, respectively.

Now that is some concentrated exposure. One would wonder why this related party, Ablecom, is not a subsidiary of SMCI. Be that as it may, here are the components, raw materials, and finished goods being round-tripped between the companies. Pay specific attention to the power supplies part as it will be helpful when I get to Compuware. Why? Cause Compuware manufactures them.

…… the Company provides certain components used in the manufacturing process (such as power supplies) to Ablecom through consignment or sales transactions.

One would hope everything is being recorded correctly and reported as such. As per SMCI, this is how the components are handled financially between the companies.

Ablecom uses these materials and components to manufacture the completed chassis and then sell them back to the Company. For the components purchased from the Company, Ablecom sells the components back to the Company at a price equal to the price at which the Company sold the components to Ablecom.

Coming to the dealings with Compuware. Apart from being a contract manufacturer, Compuware is also a non-exclusive distributor of SMCI’s finished products as highlighted above. SMCI seems to be fully reliant on Compuware for its power supply needs. Talk about concentration risk.

…. the Company outsources to Compuware..... a significant part of its power supplies manufacturing.

Compuware also manufactures motherboards, backplanes and other components used on printed circuit boards for the Company. The Company sells to Compuware most of the components needed to manufacture the above products.

SMCI has the same deal with Compuware, as it does with Ablecom. Compuware sells back finished products along with the components provided by SMCI with a value-added fee and other charges to cover its manufacturing costs.

Now that we have the financial and operational aspects of the relationship between SMCI, Ablecom, and Compuware out of the way, let’s get to the juicy part - the web of ownership that ties these companies together.

• SMCI does not have any stake in Ablecome or Compuware.

• Charles Liang and Sara Liu, collectively, own 10.5% of Ablecom’s capital stock as of June 30, 2023.

• Ablecom’s CEO, Steve Ling, drumroll, is the brother of Charles Liang. Steve and his family own 28.8% of Ablecom as of June 30, 2023.

• Bill Liang, drumroll, brother of Steve and Charles, is the CEO of Compuware, a director on the board of Compuware, and a significant shareholder. Bill also sits on the Board of Directors of Ablecom.

• Meanwhile, Steve Liang also sits on the Board of Directors of Compuware and owns a decent stake in it.

• As highlighted previously, Ablecom owns a significant part of Compuware. However, this stake is less than 50%.

Recent developments as per the 10Q for the period ended March 2024 (Refer: 10Q for Quarter ended March 2024 page 22, pdf page 25):

• Steve Liang and his family have increased their stake in Ablecom to 36% from 28.8%.

• A sibling of Charles Liang, Yih-Shyan (Wally) Liaw, Senior Vice President of Business Development and a Director, owns approximately 11.7% of Ablecom’s capital stock and 8.7% of Compuware’s capital stock.

These recent developments are certainly a show of confidence in SMCI as both Abelcom and Compuware derive the majority of their revenues from SMCI. Very interesting.

Given that, it is still quite a spaghetti of cross-holding and round-tripping. You are either shaking your head in disbelief or simply laughing out loud. But there is a little something more.

China Venture

In 2016, SMCI entered the China market by investing in a private company and entering into agreements with the company to contribute certain technology rights. SMCI owns 30% of that venture. Hilariously, SMCI refers to the entity as a “Corporate Venture” in its Annual Report. (Refer: 2023 Annual Report page 84, pdf page 93).

SMCI sold $24.2 million, $121.0 million, and $51.2 million to the China venture in the fiscal years 2023, 2022, and 2021. The current investment of SMCI in the venture is valued at $5.3 million.

Now the spicey part. The Chinese company, unnamed, which is SMCI’s partner owns 70% of the venture and is on the US government’s export control list. However, the venture itself is not a restricted party. I wanted to say something from the vaunted peanut gallery but good judgment prevailed.

Enough of the prose and poetry. Let’s have some fun with the numbers. Note that SMCI’s fiscal year is from July to June.

Cost of Sales and Gross Margin

During my email exchange with Dr. Beneish in February, he said the following (paraphrased):

NVDA seems to have been flagged due to its extremely high growth rate. However, I am very concerned about SMCI due to deteriorating Gross Margins.

How prescient was Dr. Beneish’s warning about SMCI’s gross margins in late February? On April 30, 2024, SMCI reported its Q3 FY2024 earnings for the three months ending March 2024. The markets didn’t like the gross margin guidance, sending its shares down 9% after hours.

SMCI did however raise its revenue guidance for the full year to the range of $14.3 billion to $14.7 billion and EPS to be between $23.29 and $24.09. This was based on the Q4 2024 guidance of EPS between $7.62 and $8.42 with a revenue of $5.1 billion to $5.5 billion.

Given that, let’s first look at the yearly data on how SMCI’s gross margins have evolved.

Stellar, Awesome. Cost of sales and revenue grew in steady tandem for 2021 and 2022. That is what one wants to see. Further revenue grew at a faster pace in 2023 than the cost of sales which explains the higher gross margin. Even better. No wonder SMCI went on a massive bull run.

Everything looks fine till now. Now let’s look at the most recent data for the last two reported quarters and compare the quarterly numbers year-over-year.

Even though revenues fell in the March 2023 quarter, SMCI managed its costs well and managed to maintain its gross margins. What caused the slowdown back then is beyond the scope of this article. However, we can see that in the quarter ended December 2023, Gross Margin fell by 304 basis points and for the quarter ended March 2024, Gross Margin fell by 201 basis points.

There seems to be a trend emerging. SMCI is facing input cost pressures. So, what does the management have to say about how they handle inputs and manage the corresponding costs? (Refer: 10Q for the period ended March 2024 page 37, pdf page 40).

Our cost of sales as a percentage of net sales is also impacted by the extent to which we are able to efficiently utilize our expanding manufacturing capacity. Because we generally do not have long-term fixed supply agreements, our cost of sales is subject to frequent change based on the availability of materials and other market conditions.

Based on management commentary for both the quarter ended March 2024 and the nine months ended March 2024, the following were the reasons for gross margin pressure:

1. Freight cost increases.

2. Competitive Pricing pressures.

3. Increase in costs of materials and contract manufacturing.

SMCI expects gross margins to decline QoQ, which likely reflects elevated COGS from securing liquid cooling components for upcoming shipments. While the potential margin dilutive impact from AI server sales and/or competition is a concern, SMCI reiterated its long-term 14-17% gross margin target and we believe elevated product costs from liquid cooling should normalize over time.

Goldman Sachs

Point #2 has huge implications going forward as SMCI is in a commodity business that is easy to disrupt with cutthroat pricing. Also, even though the Average Selling Price was higher in recent quarters, the higher sales prices didn’t match increases in input costs. Essentially SMCI should face further gross margin deterioration in the near term and possibly well into next year.

So, the management and Goldman have been able to explain away the reasons for gross margin compression but is there more to it than meets the eye? There is no conclusive evidence to suggest so.

However, here is what goes into SMCI’s Cost of Sales (Refer: 10Q Q3 FY2024 page 37, pdf page 40).

Cost of sales primarily consists of the costs to manufacture our products, which include: the costs of materials, contract manufacturing, shipping, personnel expenses (salaries, benefits, stock-based compensation, and incentive bonuses), equipment and facility expenses, warranty costs, and inventory reserve charges.

Good to know. Let’s plug along.

Inventory

Before diving into the numbers, here is another case of differential disclosure. As highlighted in the previous section, SMCI said they generally don’t have long-term fixed supply (vendor) agreements.

However, if one were to look at page 97 of the 2023 Annual Report (pdf page 106), there is a very important disclosure that would go on to impact SMCI’s leverage ratios and lead to shareholder dilution in Q2 2024 (period ended December 2023) and Q3 2024 (period ended March 2024).

Purchase Commitments - The Company has agreements to purchase inventory and non-inventory items primarily through the next 12 months. As of June 30, 2023, these remaining noncancelable commitments were $2.3 billion, including $70.5 million for related parties.

Another red flag. This is why I always tell people to read older reports and not just the most recent quarters’ as sometimes one will end up finding differential disclosures. One report says one thing and the other has a ticking time bomb hidden that contradicts. Nine out of ten times one will not find anything but that one time you do, it will save you a lot of your hard-earned money.

Are there any more such commitments that the company has entered into? (Refer: 10Q for the period ended March 2024 page 31, pdf page 34).

Purchase Commitments— The Company has agreements to purchase inventory and non-inventory items primarily through the next 12 months. As of March 31, 2024, these remaining noncancelable commitments were $2.9 billion, including $100.4 million for related parties.

Well, not much left to say on this other than, “Get ready for another round of dilution. SMCI doesn’t have the cash for it and isn’t generating enough to cover this commitment along with all the other growth.” More on this later.

Server technology, the bread and butter of SMCI, evolves very quickly. A new GPU is available within a few years or earlier. As soon as the new GPU is available, customers generally don’t want to do anything with the older ones. These transitions, if not well managed, can lead to inventory buildup of obsolete finished goods, i.e. servers, and lead to inventory writedowns.

So does SMCI have an issue of unsustainable inventory build-up?

All is fine till the end of FY2023. Growth is picking up and hence, some inventory build-up is expected. However, the increase in Days Inventory Outstanding does raise some concerns. However, if one looks at the last three quarters, “Whoa! What happened?” That would be the reaction of someone who didn’t bother to read the 10Qs.

On a year-over-year basis, inventory growth is tracking well below the revenue growth. Hence, stuff is moving. However, if one were to look sequentially, revenue growth slowed down to a crawl in Q3 FY2024. That would be a cause for concern. However, management guided for revenue of $5.1 billion to $5.5 billion for Q4 FY2024 at the end of April. Taking the mid-point, $5.3 billion, and comparing it to $3.85 billion in Q3 FY2024 would imply a revenue growth of 37.7% sequentially.

\(((5.3-3.85)/3.85)*100 = 37.7\)

I would hold my horses and wait till this quarter ends before passing any judgment on the inventory situation and the associated management commentary. Could it become a headache in the future? Possibly. Something to keep an eye on.

There are two kinds of inventory buildup: the good kind and the bad kind. The bad kind is an explosion in finished goods in the inventory and the good kind is an increase in work in progress and raw materials. Essentially, if finished goods are piling up, the market is slowing down and drying up. Meanwhile, an increase in raw materials and work in progress indicates that the company has orders in hand and is building up inventory to meet that demand.

While this is conventionally accepted, one would need to look at the specific company and its turnaround time to fulfill orders to make a more nuanced judgment. Given SMCI’s business, it would be rational to assume quick turnaround times, i.e., most of the fulfillment possibly happens within the quarter unless the inventory buildup happens at the end of the quarter.

In any event, let’s look at the recent quarters and see if there are any distortions in recent trends compared to its recent history.

Historically, SMCI has maintained a high finished goods inventory. Seems a little off for the business they are in. However, for Q3 FY2024 most of the financing was raised in the last 10 days of March and most probably the shipments had not occurred. Q2 FY2024 numbers are pristine and that is what one needs to see consistently. Again, I reserve judgment on this till the end of this quarter and will reevaluate, as should you.

Given that, how is SMCI financing this massive increase in working capital requirements? Even a cursory look at the Operating Cash Flow statement would show that this massive inventory buildup has caused the Cash Flow from Operations (CFO) to go deeply negative.

A negative CFO in and of itself isn’t a sign of trouble. One needs to evaluate the context behind the cash outgo. There is a good kind of negative CFO and a bad kind.

The good kind is when a company spends cash to build out infrastructure or on R&D to address a new market or build a new product that would generate revenues for years to come.

The bad kind is burning cash to keep operations going. However, if the cash is used as working capital as SMCI intends to and customer payment turnaround times are fast, it would provide SMCI a much-needed cushion to handle growth.

That said, what has SMCI done to meet this surge in working capital requirements?

Levering Up and Share Sales

First off, SMCI’s CFO is below its reported net income as was highlighted by Dr. Beneish in February. Let’s do a crude calculation to highlight this. In Q3 FY 2024, SMCI reported a net income of $402.5 million. Cash from operations was -1,519.5 million. Now, if we were to adjust it for the surge in inventory outlay, $1,657.6 million, SMCI’s CFO would have been $138.1 million. Not only is SMCI not generating enough CFO, but its adjusted CFO is less than its reported net income of $402.5 million. Another red flag.

Some of you may call it an accounting crime. Hey! You have GAAP. You have IRS accounting standards. You have management-adjusted accounting. You have Wall Street-adjusted accounting. I just joined the party.

A well-regarded accountant in the ‘80s in a huff quipped or rather, suggested renaming GAAP.

Rename GAAP to “Commonly Reported Accounting Principles”. (CRAP)

Abraham Briloff

Coming back to SMCI’s financing activities to fund working capital requirements. Let’s first look at how their cash position has evolved along with their CFO and Cash from Financing.

So, what were these financing activities? (Refer: 10Q Q3 FY2024 page 42, pdf page 45).

The increase was primarily due to proceeds of $2,314.0 million from our offerings of common stock, net of issuance costs, $1,695.8 million of proceeds from the sale of our Convertible Notes, net of debt issuance costs, an increase of $285.4 million in proceeds from borrowings, net of repayment, and stock repurchases of $146.5 million in the nine months ended March 31, 2023, offset by $142.1 million entering into capped call transactions related to our 2029 Convertible Notes and a higher withholding tax payment for equity compensation related activities of $99.5 million in the nine months ended March 31, 2024.

Reminder, all of this was done to fund working capital needs. What if there is a further surge in demand requiring more working capital? Duh! No prizes for guessing.

It would have been interesting to read the indenture for the Convertible Notes but I don’t have access to it. In any event, so how much share dilution and debt explosion has happened?

Perversely, you don’t want any more bunched-up big orders for SMCI. That $2.2 billion cash hoard looks comforting but remember the $3 billion in non-cancellable orders that SMCI is on the hook for over the next 12 months?

Bunched-up big orders would imply more dilution or issuance of debt for working capital needs for a company with little to no CFO and less than 10% operating margins along with competitive pricing pressure in a commodity business with low barriers to entry, abnormally high customer concentration, and falling gross margins.

Tax Shenanigans

Oh! I am not done yet.

All investors care about is EPS (Earnings per Share). That is the end all and be all of it. The rest of the analysis is to verify and project whether EPS growth can be sustained and by how much. Which type of EPS? GAAP? Management adjusted? Wall Street adjusted? Diluted? Whatever lights your fire. I prefer to use diluted EPS.

The interesting thing is, even though EPS is what people look at, scant attention is paid to the line above it in the Income Statement. Income Tax Expense. In reality, it is a provision and not an expense. Things to know about GAAP taxes:

1. GAAP tax accounting is different from IRS tax accounting.

2. What you see in the Income Statement, for all intents and purposes, is not what the company is paying the IRS or the states.

3. Differences in a company’s fiscal year period and IRS reporting period can create quite a lot of distortions.

4. If you see a bulging Deferred Tax Asset entry in the balance sheet, rest assured management will use it to play around with the effective tax rate to game the EPS to meet expectations or guidance as deferred taxes are just paper entries.

5. The Current Income Taxes Payable is another paper entry, with very little material meaning to it.

Let me illustrate what I mean. For the nine months ended March 2024, here are how the different reported numbers look.

Confused? Now you know why there is a whole army of corporate tax lawyers and accountants earning the big moolah. As a retail investor when you see a company playing fast and loose with their effective tax rate and other available tax credits, walk away. It is all paper shenanigans with no real economic meaning to it. They are using it to game the EPS reported to the markets.

Let’s look at how SMCI’s effective tax rate has evolved in recent times. SMCI’s IRS tax bracket is 21%.

Interesting, right? Now, let’s have some fun and see how SMCI’s EPS would have fared in the recent quarter if it used:

• The average of 2022 and 2023 tax rates. I used the tax rate from those years as those were normal growth years with not much else going on in the books.

\(((((Avg. Tax Rate '22-'23)/100) * EBT Q3)/(No. of Shares Diluted)\)

\(((((15.6 + 14.7)/2)/100) * 382.5)/61.4 = 0.94 EPS\)

• Q2 FY2024 tax rate.

\(((17.2/100) * 382.5)/58.1 = 1.13 EPS\)

SMCI reported a diluted EPS of 6.6 for Q3 FY2024. Shocked? Don’t be. How many analysts have you seen talk about tax rates? Again, I can adjust the data as I wish. As you have the right to disagree, I have the right to make my inferences and form my opinion.

I consider these tax gymnastics as non-recurring events and hence, I discard the reported tax rate when I see them blatantly off the mark. Please do remember that one person’s non-recurring event can be another person’s recurring event. Let me help illustrate my point with a quote.

I can’t define pornography in great detail but I know it when I see it.

Potter Stewart, US Supreme Court Justice (1958 - 1981)

So, this exercise with Income Statement taxes has clouded SMCI’s reported earnings. What about next quarter? Assuming all else is equal, earnings before taxes should grow close to the same rate or lower than management has guided, i.e. 37.7% as we calculated earlier. The EPS using the above tax rates would be nowhere near 8.02 (mid-point) as guided by the management.

In the press release announcing the Q3 FY2024 results, SMCI said the tax rate would be 0% (mid-point). Using management’s guidance we can infer that the growth rate of EPS will be 21.5% sequentially.

\(((8.02-6.6)/6.6) * 100 = 21.5\)

If the EPS growth rate is substantially lower than the revenue growth rate, there is definitely a deterioration in operations and most likely in gross margin. Do this calculation when earnings are released for any company and you can quickly figure out that deterioration is happening without even looking at anything else. Then you can dig deeper to help you make an informed judgment.

To be clear, nothing underhand or illegal is going on here. SMCI is using GAAP accounting rules and applying them as per their tax counsel.

As retail investors, we should be aware that this is going on and use our judgment as to whether the tax rate being used will remain negative or 0% in the case of SMCI. If these are one-off events, expect EPS to drop sharply in the future given all the other things highlighted in this article. Hence, I expect SMCI to underperform the market over the next four to six quarters.

Parting Note

I wrote this article not only to highlight what SMCI has reported in SEC fillings but also as an educational exercise. Even if only one person learns something new from this effort, I would consider it a roaring success.

Note to my college friends from 30 years ago: Thanks for the earful after my previous article. Hope this one didn’t disappoint.

Until next time. Have fun.

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Disclosures: Here are our internal governance rules to ensure no conflict of interest. For companies we write about:

1. No existing position.

2. If we have an existing position, we exit and wait seven days before publishing.

3. Wait 30 days after publishing before initiating any new position.