SMCI: What is to be done now?
A darling of Wall Street until just a few months ago, SMCI now finds itself in financial, regulatory and legal purgatory. When we took a negative view on the stock into the previous earnings call, we could not have anticipated accounting problems and the existential threat the Company now faces (link). Into the previous earnings reports we expected the Company to guide revenue soft. Instead, the Company raised revenue outlook significantly, but also missed profitability significantly. Investors were not amused.
With the Company now staring into the abyss, what does it do from an operational perspective? Company management may avoid brightening up short-term optics and instead focus on mending that which ails it. And what ails it? In getting into the liquid cooled GPU server market requiring high investment, we think the company has bitten off more than it can chew.
Inventory on hand exploded to $4.4bn exiting Fy24, tripling from a year ago vs revenue over the year merely doubling. The abrupt hit to inventory arising from high cost of liquid cooled kits for H100/H200 directly impacted margins and profitability. Cash flow from operations for Fy24 was reported negative $2.5bn vs. positive $663mn a year ago. Over the course of Fy24 the company raised ~$1.6bn in a convertible issue; a secondary offering raised $1.75bn in gross proceeds. And yet the Company exited the Fy merely neutral on a net cash basis.
In order to ensure long-term survivability, we think it has no choice but to remove the even more expensive Blackwell program off its shipment pipeline. And this necessarily means lowering Fy25 revenue guidance. Recall that the Fy25 revenue guidance of $26bn-$30bn includes revenue from Blackwell in 2FH. We think the Company’s weakened financial situation leaves it with few alternatives. Could this improve the trajectory of gross margin in the back half of the FY? It could. And that might turn out to be positive for the stock.
While we have no view into the specifics of the accounting problems triggering the Company’s external auditors to resign, we wonder if management’s response to abrupt changes to the cash flow and balance sheet items may have had something to do with it.
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The high toll of GPU servers: Even before the abrupt drop in margin reported last quarter (Exhibit 1), Company fundamentals had already begun to deteriorate. Inventory on hand began spiraling upwards (Exhibit 2) and y/y growth in opex inflected sharpy upwards (Exhibit 3). Recall that shipments/inventory of NVDA servers have been associated with the Hopper family of GPUs. Transition to the Blackwell family is likely to raise inventory and cost burden further, not just because of the higher upfront GPU cost but also due to the higher component costs associated with higher power and more complex cooling systems.
Unless SMCI does another round of capital raise, the balance sheet may not allow the additional burden of taking on Blackwell. Given the current regulatory situation, capital raise is quite out of the question.
Our view: We think SMCI may have to give up its ambitions for Blackwell servers. We expect Foxconn to take over as the lead (and perhaps the only) ODM for Blackwell. Perhaps even a portion of SMCI’s Hopper pipeline may have to be given up, to right-size the balance sheet and cash flow to the new reality.
Medium term – focus on H100: If the Blackwell program comes off the books, we think SMCI’s prospects have a better chance of mending. We may be in the minority in this view, but we think H100 servers could well become the workhorse for AI inferencing well into the future. Whereas Blackwell and its follow-ons could be the workhorse for modeling workloads, we think H100 could remain the choice for inference workloads due to rising availability, falling prices and a growing secondary market. As such SMCI may not lose much by giving up on its Blackwell ambitions and instead focus on the H100, a chip that SMCI has had quite some experience with.
With time and experience, SMCI could become more efficient in sourcing, building and shipping liquid-cooled H100. We think SMCI has a better chance of mending its inventory, opex growth and profitability if it sticks to the H100. We think demand for H100 servers is not going to sunset with the arrival of Blackwell. The two GPUs run complementary workloads. We do not expect Blackwell servers to displace H100 servers in AI data centers.
Expertise in liquid cooling systems: We find that the state of the art of liquid cooling systems for GPU server racks is surprisingly primitive. Our view is that NVDA has not been closely involved with the design and manufacturing of the liquid cooling systems. The ODM/OEM vendors have gone ahead and largely designed their own system, resulting in a hodge-podge of designs across server rack vendors. We have heard from the downstream channel that the poor design of cooling systems leads to temperature variance on the GPU board, non-optimal operations of servers and workload inefficiencies.
Among the vendors, our checks show SMCI delivers some of the better designed systems. In working closely with NVDA, we think SMCI has built up internal expertise in designing liquid cooled systems. Innovations in this arena could offer SMCI an avenue to increase customer satisfaction and profitability.
Net/Net: SMCI finds itself facing daunting challenges. The first task at hand is to mend its unsustainable trajectory of inventory and profitability. And this requires, in our view, retrenchment of its ambitions. Given its attenuated ability to raise more capital and dire financials, we think SMCI may have to lighten up on Blackwell ambitions in order to better serve the H100 market and to ensure long-term viability of the Company.
KC Rajkumar