Super Micro Computer’s sales growth is incredible, but this could be a problem for the stock

Super Micro Computer (SMCI 8.60%) has been a hot buy this year, but lately, the stock has been on a downward spiral. In just six months, it fell 27%. Its year-to-date return is still impressive at 90%, but it’s clear that investors seem to be increasingly concerned that the stock could be peaking.

The company, also known as Supermicro, has seen significant growth thanks to artificial intelligence (AI) as companies modernize their servers and IT infrastructure. Supermicro didn’t just generate double-digit growth; its top line doubled last quarter. However, revenue growth alone may not be enough of a catalyst to push the stock higher. While Supermicro is coming off another strong period of growth, there’s a more worrisome number investors may want to pay attention to: its gross profit.

Supermicro’s margins have shrunk

Increasing sales is great, but not so important if a company’s cost of revenue is high. The higher these costs, the less gross profit flows to cover operating and general expenses. If the margins are not good, it may not necessarily lead to better revenue. This is ultimately a key reason why investors are bullish on fast-growing companies – the assumption is that they will generate stronger profits, which improves their earnings multiples and can ultimately lead to a higher valuation high of shares.

But last quarter, which ended in June, Supermicro’s gross margin, which was already down to 17% a year ago, fell even further to just 11%. This means that for every dollar Supermicro generates in revenue, it incurs $0.89 in costs. This is before marketing and promotional expenses and before paying administrative staff; these are direct costs related to revenues.

This is not a new problem for Supermicro

Supermicro’s business didn’t typically generate high margins to begin with. Normally they were around 15%. But in the last quarter they fell to a new low.

SMCI gross profit margin data (quarterly) by YCharts

Now, if a company is generating 11% margins or 15% margins, it might not make a big difference to investors, but it’s still something to watch. What may be problematic is if its overhead and other costs start to rise — in the last quarter, Supermicro’s operating expenses were less than 5% of sales. If this percentage increases, it will exacerbate the problem of the company’s thin margins. And if demand starts to wane, things could go from bad to worse quickly.

Supermicro’s revenue for the period rose 143% to $5.3 billion, but its gross profit rose 60% to $596.3 million and operating income of $343.4 million was up 51 %. Those are still impressive numbers, but the danger is that Supermicro’s growth rate will inevitably slow. Businesses won’t keep spending feverishly on IT upgrades and servers forever. The artificial intelligence spending frenzy could slow down next year, especially if there is a recession. And that could have a disastrous effect on the company’s bottom line because of its problematic margins.

Is Supermicro stock a good buy?

Supermicro’s valuation isn’t all that expensive, despite its relatively thin margins. Based on analyst estimates, it trades at 15 times forward earnings. That’s not much when you consider that the average tech stock trades at a forward price-earnings multiple of 29.

The stock still looks like a good buy, as Supermicro’s margins have never been this high. Companies can make low margins work as long as other costs remain low, which is the case with Supermicro. At the current valuation, AI stock still appears to be one of the better options for investors, especially with businesses that remain strong.

Even if its growth rate slows, at a decent valuation, Supermicro’s stock comes with a nice margin of safety that could justify holding on to it, even despite potential headwinds in the near term. There is some risk here, but it may not be enough to deter investors from what turns out to be a top AI stock.