SMART Global Holdings: It Is Time To Strap Yourself In (NASDAQ:SGH)

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SMART Global Holdings (NASDAQ:SGH) has seen its fortunes take a dramatic turn for the better in recent months. The stock was in the doldrums and as recently as late April was trading in negative territory for 2023. But that all changed when interest in artificial intelligence or AI exploded in May, setting off a frantic search for relevant plays. Quite a few came to the inclusion that SGH fits the bill as a supplier of related hardware and services for high-performance computing or HPC, which triggered a powerful rally that saw SGH come close to doubling in value for the year. However, the stock has been treading water in recent weeks and it appears the stock may be getting ready for a breakout. Why will be covered next.

SGH has done much better in the last four months or so, but it wasn't that long ago the stock was in a slump. The stock spent much of 2022 in a long downtrend for various reasons, including a deteriorating top and bottom line and supply chain disruptions. A past article from last year where I rated SGH a hold covers these and other issues in greater detail. Sales and profits have fallen and it's worth noting that this has not changed, as shown in the most recent report.

However, the stock certainly has, which is why it's worth taking another look at SGH. The chart below shows how the stock was under water as recently as late April, but a huge rally in the next two months caused the stock to come close to doubling in value when it reached a 2023 and 52-week high of $29.99 on June 30. The last two months have not been so great as the stock has retreated, but SGH has still gained 63.8% YTD with the stock closing at $24.37 as of August 28.

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The chart above shows a few other things worth noting. The stock may be getting ready for a breakout in the near future. Note how the stock has respected the limits imposed by a couple of trendlines, but this cannot continue since the two trendlines are close to converging. A breakout could be followed by a sustained move higher, although the opposite, a move lower, cannot be ruled out.

The lower ascending trendline represents the trend that has been in place since the stock started its ascend in late April. The upper descending trendline represents the more recent trend that has been in place since the stock peaked in late June and then started to decline. One of these two trends is about to be broken.

It's probably worth mentioning that this convergence of trendlines has been in the making for some time. In fact, option traders seem to have been anticipating a big move for the past few weeks, if elevated option volume is any clue. Both option pricing and volume have increased, as has implied volatility, but it's not clear as to which side traders are leaning towards as both sides, long and short, seem evenly balanced.

Ditto for short interest. Short interest did go up somewhat during the rally according to the Nasdaq, going from 4,650K on April 28 to 4,926K on June 30, but it has come down to 3,604K as of August 15, not far from 3,668K at the start of the year on January 13, and before AI entered the picture. This translates to a short float of 7.6%.

SGH

Market cap

$1.2B

Enterprise value

$1.7B

Revenue ("ttm")

$1,715.7M

EBITDA

$154.9M

Trailing non-GAAP P/E

7.95

Forward non-GAAP P/E

9.00

Trailing GAAP P/E

-

Forward GAAP P/E

-

PEG GAAP

-

P/S

0.69

P/B

3.75

EV/sales

0.99

Trailing EV/EBITDA

10.98

Forward EV/EBITDA

7.74

Source: Seeking Alpha

The lack of interest on the part of shorts has not changed much, even though the stock has rallied. It's possible shorts may be influenced by valuations for SGH. The table above shows some of the most commonly used multiples for SGH. For instance, non-GAAP P/E ratios are in the single digits. On the other hand, SGH has no GAAP multiples since it is in the red in terms of GAAP.

Note that with the stock priced at $24.37, the stock can be argued to be close to fair value, which might be a major reason why shorts are staying away. It's worth mentioning that SGH has made several acquisitions in recent years, including Cree and Stratus, which have boosted revenue and EPS growth, but acquisitions have also affected the GAAP numbers due to various charges related to the acquisitions. The non-GAAP numbers are therefore a more fair representation in this case for SGH.

Accordingly, SGH is projected to end up with non-GAAP EPS of $2.66 by the time FY2023 is done. If we then assume that SGH will recover from the current earnings slump and grow EPS by 10% on average in the next three to five years, then a fair value for SGH would be about $26.60. This is not far from where it trades right now. All in all, SGH is probably not at a level that would cause most shorts to get interested.

An argument can be made that a breakout to the upside is more likely than a break lower because the factors underlying the recent rally remain in place. SGH rallied because of AI and AI alone and AI remains. Keep in mind the rally in the stock would not have happened if not for the AI craze. SGH, and the IPS Penguin Computing unit in particular, is a designer and supplier of HPC systems and related services, which in theory means SGH stands to benefit from the increased use of AI applications. This perceived benefit has trumped all else.

Nevertheless, the rally in the stock stands in contrast to the company itself. The stock has gone up, but sales and profits are going down. A look at the most recent report shows this. In Q3 FY2023, revenue declined by 17.1% YoY, and non-GAAP EPS declined by 24.1% YoY to $0.66. The table below shows how the top and the bottom line have shrunk in recent quarters.

(Unit: $1000, except for EPS)

(GAAP)

Q3 FY2023

Q2 FY2023

Q3 FY2022

QoQ

YoY

Net sales

383,330

429,174

462,540

(10.68%)

(17.13%)

Gross margin

25.7%

25.7%

24.7%

-

100bps

Operating income (loss)

(8,802)

(7,167)

35,309

-

-

Net income (attributable to SGH)

(24,455)

(27,219)

24,113

-

-

EPS

(0.50)

(0.55)

0.44

-

-

(Non-GAAP)

Net sales

383,330

429,174

462,540

(10.68%)

(17.13%)

Gross margin

28.0%

28.9%

25.7%

(90bps)

230bps

Operating income

36,300

51,431

54,272

(29.42%)

(33.11%)

Net income (attributable to SGH)

33,074

37,646

45,909

(12.14%)

(27.96%)

EPS

0.66

0.76

0.87

(13.16%)

(24.14%)

Source: SGH Form 8-K

SGH posted a GAAP loss of $24.5M or $0.50 per share. The difference between the GAAP and non-GAAP numbers is because the latter excludes $10M of share-based compensation expense, $11.6M of amortization of acquisition-related intangibles, $8.6M of acquisition and integration expenses, and $14.8M due to change in fair value of contingent consideration.

Adjusted EBITDA was $45.1M in Q3 FY2023, down from $63.5M in Q2 FY2023 and $64M in Q3 FY2022. Long-term debt stood at $782.3M, partially offset by cash and cash equivalents of $401.3M. Guidance calls for Q4 FY2023 revenue of $350-400M, a decline of 2.2% QoQ and 14.3% YoY at the midpoint. The forecast expects non-GAAP EPS of $0.30-0.60, a decline of $0.21 and $0.35 YoY at the midpoint as shown below.

(GAAP)

Q4 FY2023 (guidance)

Q4 FY2022

YoY (midpoint)

Net sales

$350-400M

$437.7M

(14.32%)

Gross margin

25.0-27.0%

23.7%

230bps

EPS

($0.13)-$0.17

$0.40

(95.00%)

(Non-GAAP)

Net sales

$350-400M

$437.7M

(14.32%)

Gross margin

27.0-29.0%

24.6%

340bps

EPS

$0.30-0.60

$0.80

(43.75%)

The results were nothing to write home about, but a look under the hood may explain why the market has been willing to look the other way. SGH is a diversified company engaged in various businesses. The table below breaks down quarterly revenue by unit. The IPS unit that is seen as a play on AI grew 83% YoY, overshadowing the decline in the other two units as shown below. Note that SGH has recently decided to sell most of the Memory Solutions unit.

(Unit: $1000)

Q3 FY2023

Q3 FY2022

YoY

Memory Solutions

148,370

265,860

(44.19%)

Intelligent Platform Solutions

170,854

95,345

83.03%

LED Solutions

64,106

101,345

(36.74%)

Total

383,330

462,540

(17.13%)

Source: SGH Form 10-Q

However, before concluding that AI is indeed the game-changer for SGH it is touted to be, there are a few things worth mentioning. First, SGH acquired Stratus, and its contributions are added to IPS. If Stratus added $40-45M a quarter, then IPS grew by around 30% YoY on an organic basis. Take also into account that the IPS unit is not solely focused on AI since HPC has a wide range of other applications.

Furthermore, there is reason to question how much AI can move the needle for SGH. Keep in mind SGH has decided to focus on services as it allows for higher margins. If AI is to drive SGH forward, it will have to be in the form of managed services and not so much in terms of hardware. From the Q3 FY2023 earnings call:

"Starting with IPS, which is comprised of our Penguin Computing and Stratus Technologies brands. We design, manufacture, deploy, and provide managed services for high performance computing for the data center, the cloud, and the edge. AI, machine learning, and data analytics are becoming foundational technologies for the success of enterprises across a growing set of industries. We believe that Penguin Computing, which has more than 25-years of experience in the deployment of HPC Systems and Solutions is well positioned at the forefront of the generative AI revolution."

A transcript of the Q3 FY2023 earnings call can be found here.

SGH does not only want to deliver the HPC hardware but also the related services. However, while some customers may be open to the idea of having SGH handle everything, it's unlikely everyone will feel the same. Some may not need SGH for everything, whether it is the design, maintenance or some other aspect they would rather keep in-house. This may become a dealbreaker for SGH.

In other words, even if lots of companies invest heavily in HPC infrastructure to support AI, SGH may only see limited benefit due to it. Note that something similar can already be observed at other AI plays. For instance, Marvell (MRVL) is also touted as an AI play, but it has yet to deliver the results that some thought would be apparent by now. AI could be a game-changer for some, like those who supply server GPUs, but that does not guarantee it will be the case for everyone.

Furthermore, there is no guarantee the current level of interest in AI will not recede if, say, it turns out AI costs more than it actually delivers. The training of AI models, for instance, is costly and it's not certain the investment can be recouped. No company can keep on spending on something if that something does not add enough to the bottom line.

AI is soaring high now, but whether it stays that way remains to be seen. AI will continue like it already has for many years, but it may happen at a much lower level than in recent months. This could have adverse consequences for those companies that have prospered solely on the prospect of what AI could deliver.

AI has certainly demonstrated its ability to move stocks. In the case of SGH, AI is the main reason why the stock has done so well since late April. The stock soared higher on the slightest bit of positive news relating to AI, ignoring all else. The market focused on strong growth in the IPS unit and looked past the fact that sales and profits have been going down. Guidance sees that continuing in Q4 FY2023. The good has overshadowed the bad, even though there was a lot more of the latter than the former at SGH.

However, this could come back to bite SGH if or when the growth in the IPS unit slows down or reverses. Keep in mind the IPS unit can be rather lumpy and it is prone to fluctuations from quarter to quarter. The market has looked past everything else for signs AI is driving growth forward at SGH. If the IPS unit disappoints, there is not much else to take its place. SGH could be vulnerable to a selloff if it turns out that AI is not powering growth ahead as hoped for, especially after the stock has rallied by as much as it has, solely based on the promise of AI.

I am neutral on SGH. The charts suggest the stock is getting ready to make a big move after being held in place by the combined force of two trendlines, although it remains to be seen in which direction the stock will be heading for after breaking out. The move could be substantial, something the options market believes is likely if rising volatility is a clue. While some may want to roll the dice, the risk of getting burned is high. The stock could move in either direction, so bulls and bears alike are at risk. Some may not want to play this game. At the very least, some may want to strap themselves in as the coming weeks could be in for a volatile ride.

Bottom line, there is little evidence AI is a game-changer for SGH, at least at this point. The market has given SGH the benefit of the doubt that the IPS unit will continue to grow thanks to AI, but this is just an assumption. It's this faith in AI that has allowed SGH to rally in recent months because it is highly unlikely it would have done as well if not for AI, especially not with all the other headwinds SGH is dealing with. These headwinds managed to keep a lid on the stock until AI entered the scene.

SGH has seen its stock get far more interest from buyers than before due to AI and this can continue, provided SGH shows just enough to keep the belief going that AI is going to power growth in the future. But if SGH comes up short because AI does not deliver as promised, it's a long way down for a high flyer like SGH.

This article was written by

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