Advanced semiconductor chips, also known as graphics processing units (GPUs), play an important role in the development of artificial intelligence (AI).
One thing that some investors may not realize, however, is that chip designers like Nvidia And Advanced micro devices are highly dependent on external parties for their chip distribution.
The rising demand for chips has served as a bellwether for increased capital expenditures (capex) in areas such as data center infrastructure. This is where Supermicrocomputer (NASDAQ: SMCI)a specialist in server rack and equipment architecture, comes into the picture.
But despite the company’s pivotal role in the AI ​​landscape, shares of Supermicro, as it’s also known, have fallen more than 30% over the past three months.
Let’s take a look at what’s driving the selling activity and why this seems like a fantastic time to buy the drop in Supermicro stock.
A look under the hood
There are a few key reasons why Supermicro was recently sold.
For starters, the macro outlook is mixed. With inflation at a three-year low, July’s reading of 2.9% is still above the Federal Reserve’s long-term target of 2%, and mixed jobs reports have investors cautious. Broad market sentiment has fueled selling activity in many stocks this summer.
Meanwhile, at the enterprise level, Supermicro generated $5.3 billion in revenue in the fourth quarter of fiscal year 2024 (ended June 30), up 141% year-over-year. As you can see below, demand trends are strong for Supermicro. However, a look further down the income statement paints a different picture.
In the same quarter, gross margin fell to 11.2%, down from 17.0% a year ago. Operating margin also shrank by about 390 basis points to 6.5%. So while revenue has increased since the beginning of last year thanks to the growing interest in AI, Supermicro’s profitability has gone in the opposite direction.
In other words, rising revenues and falling profitability figures suggest that the company is paying a high price for its new growth. A deteriorating margin profile could have adverse effects on cash flow and liquidity.
Given this inverted financial profile, I am not surprised that some investors are ignoring the stock. However, I would not panic just yet.
Why the sell-off seems overdone
Management discussed the challenges surrounding the company’s margins during the last earnings report.
Essentially, the supply and demand dynamics in the AI ​​domain are currently under a lot of pressure. This can lead to unpredictable lead times with regard to costs for products, shipping, and more. For these reasons, some companies are seeing abnormal costs that are out of proportion to revenue trends in a given quarter due to ongoing supply chain constraints.
CFO David Weigand attempted to allay these concerns:
We expect gross and operating margins to gradually expand in the year, driven by product and customer mix, production efficiency in new… AI GPU clusters and introductions of new platforms. [CEO Charles Liang] discussed, near-term shipments may still be constrained by supply chain bottlenecks for key new components for advanced platforms. However, long-term gross margins will benefit from lower manufacturing costs as we scale production in Malaysia and Taiwan, in addition to expanding in the Americas and Europe.
Weigand’s explanation makes perfect sense. As production capabilities reach higher efficiencies thanks to new manufacturing centers in Asia, Europe, and North America, Supermicro should begin to see a more normalized relationship between revenue and cost growth. This, in turn, will improve the company’s profitability numbers over time.
Why Now Is a Good Time to Invest in Supermicro
Supermicro currently trades at a price-to-earnings (P/E) ratio of 31.3. That’s a bit pricey, even for a growth stock, but the shares are trading well below their previous highs on a P/E basis.
Investing in Supermicro should be rooted in two primary ideas. First, you need to have a strong belief in AI and its ability to continue to generate impressive revenue growth for the company. But more importantly, you need to focus on the company’s path to improved profitability.
Given Supermicro’s position in the IT infrastructure landscape and the continued secular tailwinds fueling AI, the company appears to have a winning recipe.
Investors with a long-term horizon should seriously consider taking advantage of Super Micro Computer’s recent sell-off and relatively cheap valuation. It may not be long before the company shows margin improvements, and if it does, the stock could easily climb back to its previous highs.
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Adam Spatacco has positions in Nvidia. The Motley Fool has positions in and recommends Advanced Micro Devices and Nvidia. The Motley Fool has a disclosure policy.
1 S&P 500 Artificial Intelligence (AI) Stocks in the Crunch, Down 30%, Buy Now With Hands Over Hands was originally published by The Motley Fool
