Equity Insights: SMCI's business update fails to stem investor exodus

What was supposed to soothe investor concerns, failed to do so due to the lack of concrete timelines when it came to resolving its regulatory and corporate governance issues. While we welcome the independent special committee's preliminary finding of there being no evidence of fraud / misconduct, the company's inability to provide an update on its path to regaining compliance with Nasdaq's listing requirements and finding a new auditor seemed to have a bigger impact on investor sentiment.

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Following are the key takeaways from the business update shared by SMCI in their latest 8-K filing and accompanying call with analysts :-

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• Update from the Independent Special Committee created 3 months back, post EY’s initial set of concern raised :-
  
  The Special Committee has completed its investigation based on a set of initial concerns raised by EY. Following a three-month investigation led by Independent Counsel, the Committee’s investigation to date has found that the Audit Committee has acted independently and that there is no evidence of fraud or misconduct on the part of management or the Board of Directors. The Committee is recommending a series of remedial measures for the Company to strengthen its internal governance and oversight functions, and the Committee expects to deliver the full report on the completed work this week or next. The Special Committee has other work that is ongoing but expects it to be completed soon.

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• Update on the pending 10-K (annual report) filing with the SEC & the exchange, which is needed to regain compliance with Nasdaq’s listing requirements :-
  
  The Company continues to work diligently on matters related to the Form 10-K for the fiscal year ended June 30, 2024, but remains unable at this time to predict when the Form 10-K will be filed. Additionally, during the business update call with the management, the CFO of the company issued a statement stating that they are going to file a detailed plan to Nasdaq as to how they expect to regain compliance with the listing requirements and therefore seek another 180 day extension, which the exchange may or may not grant. The company essentially accepted that they are going to be unable to meet the current deadline of 16^th November, given that they are yet to find a new auditor and it is going to be nearly impossible to complete a full-fledged audit of the books within the stipulated time period.

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• Update on financial operations :-
  
  The company missed FY25 Q1 revenue expectations and barely managed to meet its mid-point guide when it came to earnings. Additionally, they also issued a very weak FY25 Q2 guide, which missed the Street consensus by about a Billion $ or 16%. The company also suspended its full year topline guidance of $26-30B for FY25. The reason provided for this soft outlook is that they had supply constraints from Nvidia, when it came to their latest chips – the Blackwell, and SMCI’s customers wanted to wait for the Blackwell servers rather than make additional spends on the Hopper.
  There were some reports which had surfaced in the past few days, stating that Nvidia has apparently routed some supply of chips away from SMCI, prioritizing other server manufacturers / partners.
  These rumors were vehemently denied by the management, and they stated that they have been in active dialogue with Nvidia who has been a partner of theirs for many decades now and as per them Nvidia has committed to provide them with the entirety of the chips that had previously been committed.
  On the balance sheet side, the company expects to report $2.1B in cash and cash equivalents and total debt of $2.3B split between bank debt ($0.6B O/S) and convertible notes ($1.7B O/S). Therefore, based on these preliminary numbers, we do not see the company to have a balance sheet issue that can potentially lead to a bankruptcy situation any time soon.

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Our view on the business, post the business update provided :-

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We see 3 critical points that are going to be impacting the future prospects of the business and therefore the stock price as well :-

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• Corporate governance issues – The company’s tainted history, along with the Hindenburg report and the more recent resignation by EY cast significant uncertainty with respect to the company’s corporate governance quality and therefore has an impact on the kind of risk premium the business is charged and accordingly the kind of valuation multiples it is awarded by the Street. Till the time that the company does not iron out the internal controls on financial reporting and potentially make some changes to its management structure to improve its functioning, we believe that the market will continue to charge it a higher than normal risk premium, which will have a deflating impact on the stock price.

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• The issue of delisting – While we continue to see this as a very real risk, what we can also ascertain from the prevailing price action and commentary from the management is that the probability of this happening seems to be low and most likely their plan to regain compliance with listing requirements will be accepted and therefore result in an additional 6 months being granted to the company. However, we cannot be sure about this outcome and will have to continue to monitor the developments to get a better idea about this.
  
  What happens in case of a delisting? – The stock begins to trade on the pink sheets / OTC market, where ownership can continue to change hands through the broker dealer network and hence facilitate price discovery. Having said that, we do believe that there will be a certain level of illiquidity discount being applied on these stocks and the quality of price discovery will also be hampered due to the limited number of players capable of trading in these markets (wide bid-ask spreads).
  
  Can the stock regain its listing status upon being delisted? – Yes, the stock can get listed on the bourses once again, upon ironing out whatever issues it had, that led to its delisting. For example, SMCI itself has previously regained its listing status after getting delisted back in 2019, when it made changes to its senior management (change of CFO) and filed re-stated financials with the SEC.

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• Impact of point 1 & 2 on the company’s business fundamentals – While we have no reason to believe that the company’s governance issues have resulted in customers distancing themselves from SMCI as of this point of time, we do see it as a risk and something that multiple sell side houses have flagged, in terms of SMCI ceding market share to the likes of Dell and HP. We have also seen some analysts price in de-growth on the topline front for FY26.
  The business update issued yesterday was disappointing, when looked at in comparison to elevated market expectations which are likely to see sizable downward revisions in the coming days. However, based on where the stock currently trades, and in terms of what sort of numbers the company will have to post in order to justify current valuations, we do not think that the numbers posted were too bad.
  
  Having said that, we would like to address the following caveat that may come up during any discussion on SMCI – Are the numbers even real? So far, the management definitely feels so, given that they have re-affirmed that they are not expecting any restatement of financials at this point of time. Whether one can trust the management on this issue is a different question altogether and one that we frankly do not have a view on. At this stage, we would need to wait for a new auditor to come in and conduct a thorough audit and see what kind of an opinion they provide.

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Overall, we expect to see limited bids on the stock till the time that there is greater clarity on point number 1 & 2. Upon the resolution of the first two issues mentioned above, the Street is likely to focus on the sanctity of the numbers and future business outlook. Assuming that the numbers are confirmed to not be overstated, we may see some buyers come back to the counter, as at that point one would be buying into the stock at a P/E ratio of approximately 10-12 times (22$ share price divided by roughly 2$ or so in EPS) or perhaps even lower if the stock were to continue correcting in the meantime.

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