One of the most important components of the artificial intelligence (AI) narrative is semiconductors. High-performance chips, known as graphics processing units (GPUs), are used for all sorts of generative AI applications.
Among the big names in the chip space is Super Micro Computer (SMCI -1.04%). Shares are up over 2,000% in the last three years. Considering the secular themes fueling AI and the chip market, in particular, Supermicro might look like one of the most compelling investment opportunities out there.
Let's break down a few important items to explore when it comes to investing in Supermicro.
1. Is Supermicro the next Nvidia?
When it comes to GPUs, Nvidia is undoubtedly the biggest force in the market right now. However, there are some important distinctions to make between the two companies.
Nvidia designs GPUs and sells them to a wide range of customers for applications in autonomous driving, advertising and e-commerce, machine learning, and more. Given Nvidia's dominant position among AI chip developers, the company has achieved a high degree of pricing power. This has led to a lucrative combination of soaring revenue and profits.
On the other hand, Supermicro is an IT architecture solution for integrated systems. In other words, it designs the storage clusters and server racks where Nvidia's chips sit.
Although Supermicro has a strong relationship with Nvidia -- which has ignited an impressive wave of revenue and earnings growth -- the company faces stiff competition from the likes of Dell Technologies, International Business Machines, Hewlett Packard Enterprises, and Lenovo.
Image source: Getty Images.
2. The business isn't the rocket ship that it looks like
The table below illustrates consensus estimates for Supermicro's revenue and earnings per share (EPS) over the next couple of years. Looking at the financial metrics below, it's hard to sour on the company. These growth projections are impressive and very well could continue even further as AI becomes ever more prolific.
SMCI Revenue Estimates for Current Fiscal Year data by YCharts.
However, I see some risks when it comes to Supermicro. Candidly, while the company provides an important service in the AI realm, storage solutions are relatively commoditized.
At the end of the day, IT architecture is a low-margin hardware business. This can be seen in the chart below, as rising investments in capital expenditures (capex) are weighing on Supermicro's operating margins. If these trends continue, Supermicro's free cash flow and overall liquidity profile could be at risk in the long run.
SMCI Gross Profit Margin (Quarterly) data by YCharts.
3. Supermicro has a premium valuation
The chart below benchmarks Supermicro against some of its peers on a price-to-earnings (P/E) basis. There's an argument to be made that the company's premium valuation is warranted because Supermicro's revenue is growing in excess of 100% annually on a consistent basis. The company is also continuing to raise forward guidance.
SMCI PE Ratio data by YCharts.
However, the disparity between Supermicro and its peers is too tough to gloss over. Dell and IBM, in particular, are diversified businesses, with integrated systems representing just one of many services. While neither company is growing anywhere near commensurate levels to Supermicro, the magnitude of the discount in valuation multiples is questionable.
Moreover, Nvidia is going to face a rising number of competitors sooner rather than later. Direct competition from Advanced Micro Devices and Intel is already here. Furthermore, big-tech conglomerates, such as Meta Platforms and Amazon, are also building their own chips in-house.
At this point, it's too difficult to know with any certainty if increasing optionality in the GPU space will help or hurt Supermicro. But considering the existing competition and the rising number of new proprietary chips entering the market, I suspect that, even if Supermicro forges relationships with these additional players, it'll come at a steep cost.
More specifically, Supermicro will likely need to continue investing heavily in research and development to build special clusters for each new potential customer. Additionally, the company will almost certainly be competing with other IT architecture-solutions providers as it pertains to price. In either scenario, I'm hard-pressed to see how Supermicro will expand margin and cash flow.
I think the chip space, in general, is a generational opportunity. However, tangential businesses such as Supermicro's may be best monitored for now. Investors looking for more steady, reliable growth might consider different aspects of the chip space or AI opportunities, in general.
