SGH - SMART Global Holdings: Rolling The Dice On A Potential AI Play

2023-12-29 09:35:13 ET

Summary

• The stock has moved around like a yo-yo for months due to the perception of SGH being an AI play, and that is likely to continue.
• SGH has yet to deliver on the promise of AI, but that could change rather suddenly, which raises the stakes of betting in either direction.
• SGH could move in either direction, depending on whether SGH is able to secure clients for AI and justify the label of an AI play.
• Betting on SGH requires rolling the dice, which may or may not pan out, something not everyone is comfortable with.

SMART Global Holdings ( SGH ) experienced quite the whiplash in 2023. After a relatively pedestrian first few months, SGH took off like a rocket in May due to being perceived as a beneficiary of the artificial intelligence or AI boom. However, the rally became completely unwound, and then some when the stock fell off a cliff in October due to disappointing quarterly results and guidance. The numbers raised doubts about the thesis underpinning SGH, particularly as it relates to AI, and it undermined the bull case for SGH, but neither did they go away. Why will be covered next.

How SGH experienced a whiplash

A previous article from August rated SGH a hold even though the stock had taken off like a rocket in the wake of an AI bonanza because there was reason to believe AI may not move the needle as much as the market seemed to expect. In fact, the article concluded by stating that "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 turned out to be rather prescient because the stock proceeded to collapse in the following months, which included a 44.4% drop in one day after the most recent earnings report, which failed to show any real signs of a boost from AI. This came as a disappointment to the market, especially considering the backdrop of how much the stock had rallied based on the assumption of SGH becoming a winner due to AI.

Nevertheless, SGH has appreciated by 29.1% YTD, but that's not the whole story. The stock rose to start the year in January, only to decline in the following months. The stock was down for the year by late April, but a powerful rally, particularly in May, pushed SGH gains for the year to over 100% by June when the stock hit a 2023 and 52-week high of $29.99 on June 30.

SGH faded in the following months. The stock then fell off a cliff on October 13 when the stock lost almost half its value in one day. SGH hit a 2023 and 52-week low of $12.66, but the stock has rallied to close at $19.21 on December 27, which means SGH has gained 51.7% in the last 10 weeks or so to pull SGH out of a hole and firmly into positive territory with a few days left in 2023. The chart below shows how SGH has gone up and down in 2023.

However, it's worth mentioning that while the stock has rallied since the October low, the rally could be getting long in the tooth. The stock is, for instance, getting closer to potential resistance levels. The recent rally could be a retracement of the move down starting with the June high of $29.99 and ending with the October low of $12.66.

The 38.2% Fibonacci retracement of this is $19.28, which is just $0.07 away. If the stock gets past the 38.2% Fibonacci retracement, then the 50% retracement is at $21.33. In addition, the stock is getting closer to the descending trendline in the chart above, which may serve as another potential source of resistance. All this could cause the rally to slow down, and may even reverse it.

Why SGH sold off after rallying

Furthermore, it's worth reminding that in spite of the rally in recent weeks, SGH is still grappling with a number of unresolved issues that have not gone away. As mentioned earlier, SGH lost nearly half its value on October 13, which is a day after SGH released its earnings results for Q4 and FY2023. Keep in mind that the stock had soared higher on the back of the assumption that SGH stood to benefit from the growing adoption of AI, especially as a supplier of high-performance computing.

The market was looking for some of that tailwind to show up in the latest report from SGH, but SGH was disappointed by coming up short. The consensus was expecting $0.45, but SGH posted a non-GAAP EPS of $0.35 on revenue of $316.7M, $0.10 less than expected. The table below shows the numbers for Q4 FY2023.

Keep in mind that SGH has disposed of its majority stake in SMART Brazil and the quarterly numbers take this transaction into account. For example, Q3 FY2023 revenue was actually $383.3M, but after excluding the Brazil unit, it is $344.4M. Similarly, non-GAAP EPS was $0.66 before being adjusted to $0.57. SMART Brazil was a lower-margin business and its absence is expected to help with gross margin going forward.

Q4 GAAP EPS of $1.17 was the result of SGH recording a one-time income tax benefit worth $70M. LED Solutions contributed $66M, Memory Solutions contributed $105.2M and Intelligent Platform Solutions or IPS contributed the remaining $145.4M. The latter is expected to benefit from rising industry interest in AI, but the unit shrank by 14.9% QoQ. Adjusted EBITDA was $37.6M in Q4 FY2023, down from $48.5M in Q3 FY2023 and $47.3M in Q4 FY2022.

Source: SGH Form 8-K

If the Q4 numbers are out, then so too are the numbers for the whole year. FY2023 revenue increased by 3.3% YoY and non-GAAP EPS declined by 4.9% YoY to $2.52. In contrast, SGH earned just $0.15 in terms of GAAP in FY2023. If not for the $70M tax benefit in Q4, SGH would be in the red. Adjusted EBITDA was $209.1M in FY2023, up from $198.7M in FY2022.

Note that the numbers exclude contributions from the recently disposed Brazil unit. FY2022 revenue, for example, was $1,819.4M if contributions from the disposed asset are included. On the other hand, the numbers do include contributions from Stratus, which was acquired in August 2022, and which gave the IPS unit a big boost.

IPS contributed $749.7M in FY2023, up from $441M in FY2022 thanks in large part to the addition of Stratus, offsetting the decline in Memory and LED Solutions, which contributed $443.3M and $248.3M respectively, both less than a year ago. SGH finished FY2023 with cash, cash equivalents and short-term investments of $390.8M, but this was more than offset by $754.8M of long-term debt on the balance sheet.

Source: SGH Form 10-K

SGH has a market cap of $991.7M with a stock price of $19.21. This means that with TTM EPS of $2.52, SGH has a P/E ratio of 7.6. Keep in mind though that this is for non-GAAP, which excludes expenses that some feel lead to a misleading picture of how profitable a company truly is. For instance, the non-GAAP number excludes share-based compensation expense of $39.2M.

In terms of GAAP, which does account for stock compensation and other expenses, SGH trades at a P/E ratio of 128 with TTM GAAP EPS of $0.15 and the stock at $19.21. The P/E ratio looks appealing in terms of non-GAAP, but in terms of GAAP, not so much. Remember that the GAAP number would look even worse if SGH was in the red without the tax benefit in Q4.

The outlook was mixed

Guidance was also a letdown. Guidance calls for Q1 FY2024 revenue of $250-300M, a decline of 13.2% QoQ at the midpoint. More significantly, the IPS unit is expected to decline QoQ. The forecast expects non-GAAP EPS of $0.00-0.30, a decline of $0.20 QoQ at the midpoint. Note that the numbers for Q1 FY2023 below have not been adjusted to account for the disposal of the Brazil unit and are included for reference only.

SGH did throw the market a bone by stating that the IPS unit would do better in the second half of FY2024. From the Q4 earnings call:

"And then on IPS, the market is favorable that way and given the lumpiness of the business and the timing of deployments and some of the variables that go in, including things like supply chain, yes, we're signaling that our current view of the world is that the second half will be better than the first half."

A transcript of the Q4 FY2023 earnings call can be found here .

Still, the latest numbers suggest SGH has yet to see much, if any, of a boost from AI, which was the main reason why the stock soared higher in mid-2023. On the contrary, while IPS is admittedly a lumpy business, it is nonetheless disappointing to see the business contracting when it was expected to see strong growth from rising business opportunities emanating from AI.

The market has not given up on SGH or AI

The stock has nonetheless clawed back some of the losses. A look at six price targets from Wall Street analysts shows four strong buys and another two buy ratings. The average price target is $26.17, well above the current price. This suggests earnings would need to grow by 10-11% on average per year according to Peter Lynch to arrive at a fair value of around $26 with TTM EPS of $2.52.

This does not seem like too ambitious of a target to achieve, especially if SGH, and the IPS unit in particular, is able to win contracts due to AI. While the IPS unit has not done great lately, that can change quickly, especially being lumpy in nature. There is no denying many companies are interested in AI and that could drive growth at SGH, at least on paper.

SGH needs to find a way to win contracts and show growth. The market is still very much interested in AI plays and that is something SGH can take advantage of if it plays its cards right. If SGH can show justification this label of AI play can be applied to SGH, then the stock could very well repeat the rally of mid-2023.

Investor takeaways

It's worth mentioning that SGH should report once again in the first half of January 2024. The consensus is looking for $0.02 less than the midpoint of guidance at $0.15. The bar has been set fairly low, so SGH has a good chance of coming up with a beat. If SGH also announces it is making progress in securing AI customers, then that could be enough to send the stock soaring. Still, nothing is guaranteed since prospective clients can always go for another vendor besides SGH.

I am therefore neutral on SGH. SGH could go either way. It all depends on how much progress the market perceives SGH to be making in terms of AI. If SGH can show AI is providing a lift as it has with some other companies, SGH could easily revisit the 52-week high. While SGH has yet to deliver on AI, all it takes is to sign up a few clients to get the ball rolling. For better or worse, it's AI what the market is most concerned about when it comes to SGH. The key for SGH is to sign up AI clients. That could change down the road, but that is how it is right now. All else is secondary.

With that said, SGH is a risky stock in the sense that betting on SGH is basically a crapshoot with AI hanging over it. SGH may find takers for its AI solutions, but it may not happen either or to the extent the market is hoping for. Betting on SGH with the stock rallying due to AI is like rolling the dice. It may pan out, but it may not also. There is no way of knowing for sure which way SGH ends up going.

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