Philip MacKellar is a writer for Contra the Heard Investment Newsletter.
A rising tide lifts all boats, right? Well, oftentimes, but there are exceptions to this overused yet useful observation.
Take the artificial-intelligence boom and the tale of Super Micro Computers, a California-based IT corporation that builds data servers and storage systems. Its products cater to clients operating in a variety of fields, including cloud computing and data centres.
While chip makers such as NVIDIA Corp. NVDA-Q are reaching new highs and other AI heavyweights are roaring upward, Super Micro Computers Inc. stock is down on the year. The ticker soared over 330 per cent in the first quarter, and the firm was added to the S&P 500 in March, but it has lost more than 75 per cent of its value since then.
So why didn’t the tide lift this boat? Or more to the point, why did the tide start to lift this boat only to dash it against a cliff? Though the company’s place within the tech sector positioned it well to ride the AI wave, it also has a history of accounting issues.
In 2018, the enterprise was briefly delisted from the Nasdaq after delaying financial reports and engaging in various accounting violations between 2014 and 2017. The transgressions ranged from prematurely counting revenue to improperly recognizing sales; the firm did so by engaging in activities such as sending goods before requested delivery dates and changing shipment terms.
These practices resulted in the removal of the chief financial officer and a US$17.5-million settlement with the US Securities and Exchange Commission in 2020. Unfortunately, old habits die hard, and that was not the end of the accounting shenanigans or accusations against the company.
In August, short-selling shop Hindenburg Research published a report accusing SMCI of accounting manipulation. On the heels of that publication, the executive team announced a delay in the annual filing. Hold-ups of this nature are nearly always negative.
After this news, Super Micro received a non-compliance letter from the Nasdaq in September, which noted the company had 60 days to file its annual report or submit a plan to avoid being delisted. The Nasdaq could grant an additional 180 days to regain compliance, but it is unclear if the exchange will.
The severity of this issue and the daunting nature of the task was thrown into sharp focus when auditor Ernst & Young LLP resigned in late October. This sent the stock into a tailspin as it increases the odds of missing the Nasdaq’s compliance deadline, as well as the probability that the SEC launches an investigation.
Then, on Nov. 5, management provided the market with “preliminary financial information” for the latest quarter and updated investors on its woes. The release states “the Audit Committee has acted independently and there is no evidence of fraud or misconduct on the part of management or the Board of Directors” – hardly a reassuring statement given its brevity and lack of detail. No timeline was given for filing the annual report, and no outlook was provided on when the organization would be back in compliance with Nasdaq requirements.
To make a long story short, a rising tide does not always lift all boats – perhaps only those without leaks. In this case, the accounting problems trumped the strong AI macro story, and owners paid the price. The valuations were arguably too rich in the spring, regardless of accounting issues, which means there was no margin of safety investing in this name earlier this year. This has made the subsequent downturn even more crushing.
The question now is where the story goes from here. On the one hand, it could get a lot worse before it gets better. The board of directors could struggle to find an auditor, the shares could be delisted, the SEC could sue them, owners could sue them, executives could be shown the door leading to even more disarray, and major accounting issues may invalidate a lot of the historic financials. In the worst case, the corporation could vanish if the accounting problems are material enough.
On the other hand, Super Micro has been here before and has gone on to thrive in the aftermath of accounting problems. Depending on what the financial restatements eventually reveal, the company could be cheap and reward brave owners with a meaningful recovery.
As a contrarian investor, who is interested in such beaten down names, I will be waiting for the restated financials. This could take a long time but is critical before getting serious about investing – it is nearly impossible to value what the enterprise should be worth without reliable financial statements.
I would also like to see the name out of the headlines, a turnaround plan in place, and net insider selling decline or even flip into net insider buying. The stock could rally without these ingredients, but betting on such an outcome would be speculative.
The final point to highlight here is one that Warren Buffett likes to make. In the past, he and his late business partner, Charlie Munger, have pointed out that revolutionary industries with excellent prospects (such as AI) may make wonderful contributions to society, but that does not necessarily translate into good returns. In fact, shareholders may be left holding the bag or losing their shirts.
Take automobile stocks listed in the 1910s and 1920s, for example. During that era, there were thousands of automobile makers in the United States, many of which were listed, yet most of them went bankrupt early on. Those that did survive competed against each other to the point where returns on capital were low, and eventually, there were only three publicly traded U.S. automakers left. To add insult to injury, two of them then went bust during the 2008-2009 financial crisis and had to be recapitalized.
Mr. Buffett and Mr. Munger went on to note how similar experiences have befallen airlines from the 1950s, semiconductor manufacturers in the 1970s and internet start-ups in the 1990s. I would also add SPAC financed electric vehicle startups and pot stocks to this list. In the case of AI, it is likely Super Micro Computers will be merely one of many industry peers that failed to live up to the hype.
For our part, the name is going on our watchlist of contrarian stocks. We will watch the story unfold and wait to see if it can find its footing in the quarters ahead.