SuperMicro's Accounting Problems May Force A Near-Term NASDAQ De-Listing

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Summary:

We are short SuperMicro Computer (SMCI) because we believe there is a significant risk that the stock will be de-listed soon after the August 24^th NASDAQ-imposed deadline for SMCI to file its delinquent financial reports by. A mosaic of irregularities including recent changes in the company’s disclosures lead us to believe that SMCI could miss this deadline, causing a de-listing.  We see substantial downside potential because exchange de-listings historically have led to indiscriminate liquidation of the stock by index and mutual fund holders who are prohibited from owning shares that don’t trade on an exchange. 

SMCI makes computer components and assembles servers used by enterprises looking to customize their computing infrastructure. The company has been unable to file its financials since August 2017 when the Audit Committee began an investigation and review of accounting issues discovered as part of the then in-process audit.  Since then, three senior executives have resigned, including the longtime CFO and a co-founder who headed international sales.  Bulls argue that the accounting issues are benign and have created an opportunity to purchase a growth business at a reasonable price.  We disagree and believe investors are overlooking warning signs, including:

•          Additional risk disclosures buried in a July 13^th 8-K now warn that the company may miss the NASDAQ filing deadline despite the company having previously said in May that it “remains on track” to make its delinquent filings in time.   In our experience, companies only make these kind of language changes if the underlying circumstances have materially changed for the worse.
•          We discovered an apparent undisclosed related party, a Taiwanese lighting business funded by SMCI and run by one of the Chairman’s brothers.  This is on top of a lengthy (but disclosed) list of additional related party transactions involving the company’s largest supplier co-owned by the Chairman and a group of SMCI distributors run by the Chairman’s other brothers from locations near SuperMicro.  The extent of these relationships is worrisome because related party dealings have featured prominently in previous corporate scandals.  
•       There is over an $850 million difference between what SMCI says it has earned and the cash it has actually generated, a gap we find highly irregular. Despite reporting $722 million in cumulative pre-tax profits over the past decade, the business generated negative $166 million in free cash flow over this period. Accruals have ballooned to the point that reported receivables and inventory amount to over $1 Billion while the company’s cash conversion cycle has soared to record highs.
•       We see indications of a compromised corporate control environment that could allow serious accounting problems to fester.  The Chairman’s wife has been the company’s Chief Accounting Officer for the past 20 years and the former CFO “ran the shop without any FP&A [Financial Planning & Analysis] staff whatsoever”. The Chair of the Audit Committee is an investment banker from Needham, an underwriter of SMCI’s IPO.  
•        Allegations of accounting impropriety by former employees emerged in an amended complaint from a shareholder fraud suit that was dismissed in June (now being appealed).  According to the former employees, the company shipped excess product to customers that was later returned, altered purchase orders, and improperly used marketing credits to compensate distributors.   If these allegations are true, SuperMicro’s accounting problems could be both far worse and more pervasive than investors have thus far been led to believe. 

Yes, SuperMicro has "real" business activity, but we are uncertain if the company's recent accounting problems are simply a product of poor controls or outright financial manipulation. In either event, the overall mosaic makes it difficult for us to believe the company will be able to file two audited 10-Ks and three 10-Qs by August 24^th. That's exactly why we see a NASDAQ de-listing as a significant downside risk that has yet to be recognized or fully discounted by the marketplace. 

SuperMicro’s Accounting Problems and Potential NASDAQ De-listing

SuperMicro has been unable to file its financials with the SEC since delaying its 10-K in August 2017 and is now approaching the August 24^th NASDAQ-imposed deadline to file its financials or face de-listing soon afterwards from the exchange. Because exchange de-listings force a stampede of index funds and institutional investors to liquidate en-masse, these events have been catastrophic for stock prices of de-listed companies which often plunge 30-50% in a matter of days. For example, shares of both SNCR and SCOR tanked after being de-listed for having delinquent SEC filings (below). The trend towards indexing has made the impact of de-listing events more pronounced because passive investors comprise an increasingly large portion of the shares outstanding.  If SMCI were to be de-listed, we estimate that at least 20 million shares would need to be sold, equivalent to more than 52x the average daily volume.

SMCI has disclosed that the in-process audit of its financials for the fiscal year ended June 2017 led to an inquiry involving a sales transaction that “was reversed and subsequently recognized in the quarter ended March 31, 2017”.  The Audit Committee then “initiated an independent investigation to determine whether there were any similar transactions”.  Since then, three senior executives resigned abruptly in January, including the longtime CFO and a co-founder who headed international sales. Shortly afterwards, SMCI disclosed that the Audit Committee had completed its investigation but, notably, did not release any results. Instead, SMCI stated that “the Company is unable at this time to provide a date as to when the Form 10-K will be filed or to determine whether the Company’s historical financial statements will be adjusted”.  Throughout this process management has released preliminary financial information but has kept investors in the dark by refusing to answer questions about the investigation on each of its three most recent quarterly conference calls.  

SMCI presented a compliance plan to a NASDAQ hearing panel in April and stated in a May 21^st 8-k that “the company believes it remains on track to file the delinquent reports with the SEC and thereby evidence compliance with the Rule on or before the panel deadline of August 24, 2018” (emphasis ours).  But, ominously, this language was omitted from an 8-K filed on July 13^th discussing listing deficiencies.  SMCI even buried a new risk factor in the filing’s forward-looking statements which warns about “the Company’s ability to timely make its SEC filings in accordance with the terms of the Panel’s listing exception and the Company’s compliance plan related thereto; the company’s ability to make all other SEC filings”.  So why is SMCI now warning about its ability to file the financials in time?  Is there a larger accounting problem at the company?

Irregularities and Allegations of Accounting Impropriety at SuperMicro

SuperMicro was founded by Chairman & CEO Charles Liang who has created a culture described in a New York Times profile as being akin to a Chinese “family-run farm”. Liang’s wife, Sara, has been the Chief Accounting Officer and Treasurer since 1993. An SMCI representative told us that the company’s former CFO, who had been at SMCI since 2006, “ran the shop without any FP&A [Financial Planning & Analysis] organization whatsoever”.  The Chair of the Audit Committee is an investment banker from Needham, an underwriter of SMCI’s IPO. We fear that this is exactly the kind of environment that could allow serious accounting problems to develop over time.

We discovered the existence of an apparent undisclosed related party which we see as an indication that SuperMicro’s corporate control environment is compromised.  SuperMicro made an undisclosed investment in Aeon Lighting, a Taiwanese business run by Chairman Liang’s brother, James Liang, according to documents including an Aeon marketing presentation (here). Aeon makes several references to SMCI’s financial backing and even claims to make use of SuperMicro technology in its products.  Yet we see no mention or disclosure of this relationship in SMCI’s SEC filings.

This comes on top of myriad other related party transactions that the company has disclosed. SuperMicro’s largest supplier, Ablecom, is 10.5% owned by Charles Liang and operated by his Brother, Steve Liang, who owns 36%. SuperMicro purchased $671 million in products from Ablecom over the last three reported years, according to the most recent proxy filing.  The proxy states that Ablecom owns a stake in CompuWare, a SuperMicro distributor run by another brother, Bill Liang, that is located on the same street as SuperMicro, Ablecom, and Aeon lighting in Taiwan. CompuWare’s website states that it also owns numerous branches and “registered distributors” operating under different names located in North America, Asia, and Europe.
 

We also find it curious that SuperMicro generates no cash. Although SMCI has reported $694 million in cumulative pre-tax profits over the past 10 years, the business has generated negative $166 million in free cash flow according to Bloomberg data.  Said another way, there is over an $850 million difference between what SMCI says it has earned and the cash it has actually generated.  We see this as a classic red flag and note that the balance sheet increasingly consists of accruals for accounts receivable and inventories, which totaled over $1 Billion as of June, 2017.   The company’s cash conversion cycle has similarly soared to a record 98 days as of the last reported period, nearly double what it was in 2010.

SuperMicro has a history of delinquent filings and completed a small restatement in 2015 related to warranty expense.  This triggered a stockholder suit (Case 5:15-cv-04049-EJD) that quietly made its way through the courts before being dismissed in June for failure to plead an actionable claim (a ruling that has since been appealed). The amended complaint (here) that was filed last December included allegations from four former employees that suggest SuperMicro’s problems are far bigger than what has thus far been disclosed.

According to the complaint, a former sales manager observed “salespeople shifting the dates on purchase orders at the company” and that SuperMicro “shipped products without the consent of the customers, and that customers refused shipments…when the systems were returned, SuperMicro had parts that had to be scrapped.” Also, “VP of Strategic Accounts [Gloria] Sun shipped products and asked customers to hold the products, knowing that the products were not what the customers wanted and that the products would be returned”, which appears to describe a bill and hold scheme.  The complaint specifically alleges that management and specifically SuperMicro’s now-former VP of Worlwide Sales [Phidias Chou] as being specifically aware of the wrongdoing, which is notable because Chou was one of the three senior executives that resigned in January.  

These alleged misdeeds are worrisome because over 44% of SuperMicro’s sales are to distributors and third-party resellers. SuperMicro recognizes revenue as soon as products are shipped to these parties as opposed to when the product is actually sold to the end customer.   Fraudulent companies have historically abused this accounting policy by shipping excess product before the end of quarters to meet financial targets. We find it notable that SuperMicro’s distributors have return rights in the first 60-90 days and also “at product obsolescence” causing us to wonder if risk is always being transferred to distributors when SuperMicro records revenue.

The complaint also details accounts of former employees who say they observed the company improperly using marketing credits to discount product and compensate distributors. One former employee stated that “the Company’s marketing credits were supposed to be used for co-marketing, but that the company routinely used these credits to provide discounts to customers for current purchases” and “there were “numerous instances where the marketing credits appeared on invoices as a discount”.  This allegation is troubling because companies have historically mis-used incentives to distributors as a device to manipulate their financials. According to the complaint, a former employee who was a credit and collections analyst stated that “the volume with respect to accounts receivable was insane” and “the company’s collections department consisted of only four collectors and they were serving approximately 1,400 accounts”.  We note that SMCI’s last 10-K includes a footnote briefly referencing “receivable financing arrangements” which suggests the company is engaging in some sort of factoring operation and that accounts receivable would otherwise be even higher.

We are uncertain if SuperMicro's recent accounting problems are simply a product of poor accounting controls or outright financial manipulation, as the former employees referenced in the complaint assert. In either event, the overall mosaic makes it difficult for us to believe that the company will be able to file two audited 10-Ks and three 10-Qs by August 24^th.   We note that SMCI recently issued a press release on July 30^th scheduling an August 7^th conference call and release of “preliminary information regarding its financial results”.  But by referring to just “preliminary information”, SMCI’s language strongly implies that neither complete financials or SEC filings will be included in this forthcoming release.

We also find it notable that SuperMicro has recently placed job postings for key finance roles such as VP of Internal Audit, Sr. Director of Financial Planning & Analysis, Assistant Corporate Controller, Senior Revenue Analyst, Senior Accounting Manager, and Senior Corporate Auditor.  Duties that stood out to us from these postings include:

• “partner with the legal and compliance organization on the investigation of whistleblower complaints and other matters”
• “follow up and appraise implementation of corrective actions”
• “manage the preparation of the financials”
• “assist and provide support for external reporting – 10Q/10K”
• “participate in 404 SOX project” [Sox 404 refers to internal control procedures]
•  “resolving issues or questions about unusual account balances, “researching balance sheet account variances”
• “function as key owner of internal controls”  
• “assisting in resolution of accounting problems arising between internal departments”

While adding these positions may signal that the Audit Committee is serious about improving the company’s internal controls, we doubt SuperMicro would be making these hires unless material problems in these areas have been uncovered.  These hires also strike us as the kind of additional horsepower that SuperMicro would need to fix accounting issues and internal control deficiencies.  By contrast, if SuperMicro’s financials were in good order and ready to be filed, why would the company now choose to make senior-level hires of people that are clearly integral to the preparation of the financials?  The timing just doesn’t make sense to us unless there are lingering problems with the SEC filings, especially considering the new warnings SMCI buried in their July 13^th 8-K.

Conclusion

We believe there is a significant chance that the stock gets de-listed, an event that historically has triggered severe share price declines due to the forced liquidation of index funds and institutional investors.  If SMCI somehow manages to bring its financials current before the deadline, we have difficulty seeing large upside potential at current valuation levels.   Shares currently fetch around 7x Enterprise Value /estimated trailing EBITDA, a modest discount to the 9x average multiple the stock has traded at during that past 10 years.  SuperMicro’s balance sheet increasingly consists of accruals for receivables and inventory and until SuperMicro can translate reported EBITDA into actual free cash flow, we doubt investors will pay much of a premium for the shares.  We also think that questions about the company’s earnings quality and lax corporate control environment will persist, including the business rationale for the myriad related party entanglements involving Liang family members.  In our view, there are significant downside risks at SMCI that have yet to be recognized or fully discounted by the marketplace.