SMART Global Holdings Is Undervalued, Expanding And Relatively Safe From Recession

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About: SMART Global Holdings (SGH)
by: Anthony Garcia
Summary

SGH is a worldwide supplier of memory for phones, desktops, laptops, and other uses, and they are the largest memory supplier in Brazil.

Acquired Penguin Computing, a diverse tech company with the ability to provide new distribution lines for SGH's main products, and will expand the product line with artificial intelligence offerings.

Very strong earnings growth, with FY 2018 Q4 beating FY 2017 Q4 by 73% (non-GAAP). Projected to increase earnings by 8.1% year-over-year.

SGH is a "growth at a reasonable price" stock with a medium level of risk.

A Stock Ready to Reward Long-Term Holders

SMART Global Holdings (NASDAQ:SGH) has positioned itself very well to reward shareholders in the future and I see it being a good opportunity for a long-term hold.

Here's the quick breakdown and then I'll get into it a bit further.

The Good:

  • They are the leader in the growing economy of Brazil for specialty memory - an economy that just came out of a recession and is expanding.
  • They acquired Penguin Computing - giving them new distribution lines, government and large corporate contracts, and a big step in the door for artificial intelligence.
  • FY 2018 was the first year they made money and they had huge growth in doing it, and the overall market hasn't reacted to that in full, leaving a value opportunity.
  • Their financials indicate a forward looking management team - more on this down below.

The Not-So-Good:

  • They're a small company (market cap of $781M) and may not be able to ride out every storm.
  • They carry a lot of debt at 98.4% long-term debt to equity.
  • Their gross margins are low compared to the rest of the industry.
  • They're in an industry that's seeing its peak in the cycle right now in the United States.

The Good

Brazil

SMART has established itself as a market leader as the largest in-country manufacturer of mobile memory products for smartphones, and the largest in-country manufacturer of memory components and modules for desktops, notebooks, and servers.

From SGH's Investor Relations Page

Currently Brazil is the world's eighth-largest economy (by GDP), coming out of a recession last year and growing again. The market segment that SGH operates in is looking very strong with lots of opportunities for further growth:

  • Currently 54% of Brazilian adults own a smartphone, with the total number nearly doubling every year since 2013. (Source)
  • Tablets are very popular with almost 15% of the country using them to access the internet - making Brazil the 3rd most "tabletized" country in the world. (Source)
  • PC sales are up 21% quarter over quarter for 2018 with the first quarter seeing 1.34 million computers sold; 60% being notebooks and the rest desktops. (Source)

These devices all require specialty memory to be fitted to their specifications including speed, capacity and form factor. In order to do that many times "off the shelf" products will not work, and the OEM companies that make these devices will need to work with companies like SGH in order to fulfill that requirement. A notable exception to this is many desktop PCs, however SGH can provide components for those as well and does partner with OEMs on this front. Overall their specialty memory segment is up 20% year-over-year.

Also of note is that they have began producing polymer cell-based batteries for smartphones in Brazil – with an estimated market of around $400m in that country. This shows an excellent use of existing facilities to continue to expand and it goes nicely with their other product lines in order to expand the amount of products they can offer to their customers.

Their Brazilian operation represented 61.8% of their entire revenue for FY18 (source).

Penguin Computing

SMART... announced that it has acquired Penguin Computing, Inc., a privately held company and a leader in specialty compute and storage solutions targeting applications in Artificial Intelligence, Machine Learning and High-Performance Computing using state-of-the-art, open technologies and advanced industry architectures.

From SGH's Press Release on the Penguin Acquisition

If you will navigate to the above link you'll see some of Penguin's financial data at the bottom. In FY17 they had a gross profit of $30m, and they had grown their net sales and gross margin by 80% and 77%, respectively, from Q1.FY17 to Q1.FY18. They finished Q1.FY18 with a modest bottom line of $2m as compared to Q1.FY17 at $0.4m giving them a five-fold increase quarter-over-quarter.

Penguin was making money by itself and will only add to SMART's bottom line at this point. I'm not a fan of companies that don't make money, so it's good to see this acquisition was an immediate boost to the bottom line income. SGH has stated Penguin will be accretive to EPS in FY19.

Taking on Penguin Computing gives them a number of new opportunities:

  • New lines of distribution for existing products. Penguin provides custom computing solutions for enterprise and government applications and this easily allows SGH to provide specialty memory for all of these sales.
  • Government and large corporate contracts to provide high-performance computing artificial intelligence, giving them an additional stable source of income moving forward.
  • A foot in the door with AI research and development. Penguin is partnering with Nvidia (NVDA) and Intel (INTC), two of the leaders in AI. I personally believe investing in AI now is a fantastic idea for the long term.

All of this taken together indicates that Penguin will be highly supportive of their existing business structure and provide them with new avenues to continue to expand.

Source for the above.

Growth or Value?

On OCT-4-2018 SMART reported its FY18 results and guidance for FY19. It was nothing short of staggering compared to where they'd been, and the stock price reflected it. Let's dive in to the nitty gritty.

First off they beat FY17 by 69% on net sales (up to $1,289m over $761m) and in doing so set their FY18 EPS at 5.17 (GAAP) over FY17's at -0.38.

What's even more impressive is they made real cash for the first time and the bottom line looks like a healthy small company just starting to turn a good profit. As I mentioned before I will not recommend or purchase a stock that doesn't make money. Let's look at the bottom line here.

Fiscal Year FY18 FY17 FY16 FY15
Net Income (Loss) $M 119 (8) (20) (46)

(Source)

In the earnings call (transcript) they also issued guidance on Q1 FY19 calling for GAAP earnings of $1.49 - $1.54 vs. Q1.FY18 at $1.05. On the high end that's a 46% growth.

Now so far this looks like a growth stock, and I'd agree with that. But I think it's growth at a reasonable price. Let's look at some more key metrics.

Price/Earnings PEG Ratio Price/Sales Price/Book Price/Cash Flow
6.47 0.10 0.58 4.94 5.08

(Calculated from financial statements, stock price, and GAAP earnings)

P/E, PEG and P/S are very attractive (especially when compared to the rest of semiconductors). The price/book isn't. I don't care for that P/B, to be honest. However, given that SGH's business model focuses highly on the service side of semiconductors (especially given acquiring Penguin), I don't think it's a big factor here.

Now let's talk the stock price. On Oct. 5 they got a big jump from 32.37 to 35.01 at the close. The volume was tremendous on that day. Predictably on the days following some took profits. It's been trading in a bit of a channel since then, but with recent bullish technicals and an obvious spot of resistance at $35. Prior to the Penguin acquisition it was trading around $50.

I don't think the market priced the acquisition properly. It looks to me like a lot of shareholders saw the acquisition and panicked, worrying that SGH was taking on more than it could chew without really looking over the facts. It might have been overvalued before - but the P/E calculated right now at $50 for this year's estimated EPS only gives us 7.26 - so I don't think it was overvalued at that price before and it certainly wouldn't be now. I think that drop in the price was a vast overreaction. Not like the stock market doesn't do that from time to time.

A quick and dirty valuation method takes the YoY earnings growth to help us find a valuation and it looks very undervalued there as well. The growth rate from FY18 to projected FY19 is 8% using non-GAAP EPS (6.88/6.36 = 1.08). 8 x 6.88 = $55.04/share. It's a quick and dirty method but ends up being close on small-mid cap stocks usually.

On the valuation front it's also quite notable that from Oct. 1, 2018, until Dec. 1 2018, SGH gained about 20%, whereas the broader market is in correction territory. That would indicate a lot of technical strength for the stock.

So that gives us a buying opportunity right now at a very attractive price. It's early in SGH's maturation as a company, but the indicators so far look promising.

The Not-So-Good

They're a Small Company

I love small business and small-cap stocks, I really do. But they're inherently risky. We don't know a ton about them yet. We don't know how they'll react to booms and busts, how they have prepared themselves for a recession, or how they'll spend their money when they make it. All of these factors are, to some extent, unknowns in all companies - but at an all-time high in small ones.

They don't have a ton of cash on hand - only $39m last quarter (although some of it likely went to Penguin as they had $64m the quarter prior). This is a bit of a tricky situation. They have only a tiny bit of breathing room here. They can handle some small problems but a couple big ones in a row and they'll have to take on more debt and they've already got plenty (see the next section).

Debt

The company has quite a bit of debt. It's long term debt/equity is at 98.4% (source for their balance sheet). Yikes. But that does include the money it paid for Penguin. Compared to its industry with an average around 50% (source) it's not doing well in this regard.

It was paying down its long-term liabilities fairly quickly from 2015 – 2017 (dropped from $235m to $154m), then took on more this last fiscal year to pay for Penguin, finishing FY 2018 at $184m. It's important to note that it was making far less money in 2015, yet obviously able to pay down its debt fairly quickly while burning cash. Based on its prior performance I don't think there's any reason to worry about paying off that debt.

The rest of those liabilities are mostly accounts payable. It has maintained a balance around $200m since 2015 and doesn't appear to be struggling with it. I'm not very comfortable with the level that high - especially with risks in foreign currency exchange, but they noted they're taking steps to combat that by paying all vendors in Brazil as quickly as possible.

The high amount of debt they're carrying is risky given that they're a small company just finding their legs. I'd be more concerned though if they hadn't made a historically concerted effort to pay it off. They obviously understand the importance of paying it to allow for future expansion (like Penguin), and for that fact I'm not going to count the total debt load against them too hard.

Gross Margins

Their gross margins are low for semiconductors at 22.6% (source) and the average is 55.63% in the industry (Q3 2018). This won't allow them to weather all the storms that they may come up against. But is it really a problem for SGH?

Considering their business model is pretty heavily weighted on service, with manufacturing only in Brazil, it doesn't look that bad. Most service companies get loaded down on their COGS and thus have low gross margins. Once you start to look at SGH more like a service company and less like a chip manufacturer the low GM starts to make sense.

Cycle Peak

Right now we're seeing semiconductors likely coming to a bit of a peak in the US. They'll have to rely pretty heavily on their Brazilian market in the coming years as the US likely enters a recession. They still have some more growth opportunity before that hopefully, however ,so they have some time to stockpile cash and gain customers.

Besting the cycle and coming out of the recession intact will be the first true test of this company's leadership mettle. If they steer the company in the right direction and open up their lines of distribution (like with Penguin) then they'll be far better able to weather the hard times. I feel the management is very forward looking in this aspect based on that acquisition.

Conclusions

I believe SGH provides a more than adequate return for a long-term shareholder, however the safety of principal is in question based off a few simple facts:

  • They're small and the financials reflect it
  • They have a lot of debt
  • The US will likely soon be entering a recession and small companies will lag behind

These things are mitigated by:

  • A good presence in a foreign, expanding, economy
  • Fantastic growth
  • Great value at present

Based on this I wouldn't recommend larger than a 3% position in any portfolio, and only if the investor is willing to take a medium risk. I personally carry this stock at a 3% position and have an approximately 20-year time horizon.

Disclosure: I am/we are long SGH. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.