How Bad Is This News for Super Micro Computer?

Super Micro Computer (NASDAQ: SMCI) has been one of the early stars of the artificial intelligence (AI) boom. The maker of servers, workstations, and other equipment critical to data center operations has seen revenue rise in the triple digits in recent times due to demand for its products. And that's helped the stock take off, soaring more than 4,800% in the five years through February -- and Supermicro continued the momentum in the first half of this year, climbing 188% to even beat market darling Nvidia.

But the second half of the year has been difficult for the AI equipment giant. A series of headwinds -- including a short report alleging troubles at the company -- have weighed heavily on the stock. And just this week, news that EY, formerly Ernst & Young, resigned as Supermicro's auditor, citing concerns about the company's internal controls over financial reporting. The stock sank 32% in one trading session. How bad is this news for the AI equipment maker? Let's find out.

Image source: Getty Images.

Three pieces of news that have hurt Supermicro

First, though, let's talk about the three pieces of news that have pressured Supermicro over the past few weeks. In late August, Hindenburg Research released a short report, saying that in its own investigation it found "glaring accounting red flags" and other problems at the company. Supermicro responded, saying statements in the report were "false or inaccurate."

And it's important to keep in mind that Hindenburg, holding a short position in Supermicro, was set to gain if the stock fell -- this bias made it difficult for investors to rely on the research firm as a source.

Meanwhile, Supermicro delayed the filing of its 10-K annual report, a move that prompted investors to worry about potential problems. Supermicro addressed this issue too, saying it didn't foresee any significant changes to fourth-quarter or full-year earnings figures.

A few weeks later, The Wall Street Journal, citing people familiar with the situation, reported that the Justice Department had launched a probe into Supermicro. Spokespeople for the U.S. attorney's office and for Supermicro declined to comment when contacted by the newspaper.

These events added uncertainty and risk to the Supermicro story, making it one cautious investors were better off avoiding. Still, since we didn't have facts to confirm the above issues, a bargain valuation of around 15x forward earnings estimates during the past two months made it a stock some very aggressive investors could consider.

Should you avoid Supermicro stock?

The resignation of EY doesn't confirm the headwinds I've mentioned above. But it does prompt me to say all investors now should view the stock with caution and watch and wait as this story develops. This is because the firm, as an auditor, is an unbiased party and generally has a clear view of internal financial controls.

EY's words below suggest a lack of faith in management, a major problem for an auditor and just as big of a problem for an investor. Before investing in a stock, it's crucial to have confidence in the company's management team, and this includes how the team oversees accounting practices and overall strategy.

EY, in its resignation, wrote: "We are resigning due to information that has recently come to our attention which has led us to no longer be able to rely on management's and the Audit Committee's representations and to be unwilling to be associated with the financial statements prepared by management, and after concluding we can no longer provide the Audit Services in accordance with applicable law or professional obligations."

Problems signaled in July

EY initially signaled concerns in July, and Supermicro's board appointed a special committee to review the matter. The review remains ongoing.

Supermicro, in a filing with the Securities and Exchange Commission (SEC) to announce the auditor's resignation, responded: "The Company has taken the concerns expressed by EY seriously, and will carefully consider the findings of the Special Committee and any remedial or other actions recommended by the Special Committee following conclusion of the Review."

It's positive that Supermicro aims to address any problems, but this doesn't remove the risk linked to the stock right now. And that's why it's best to hold off on investing in Supermicro stock as this story unfolds. What's also troubling is this isn't the first time Supermicro has faced accounting issues. The SEC ordered the company to pay a $17.5 million fine for "improper accounting" back in 2020.

Does this quash Supermicro's bright long-term prospects? After all, the company is a leader in the AI server market, is seeing strong demand, and may have a new growth driver ahead as data centers adopt direct liquid cooling (DLC) technology (an area of expertise for Supermicro). Supermicro still could excel over time, but without clarity regarding the accounting situation, it's impossible to draw conclusions. And that's why Supermicro remains a company to watch -- but from the safety of the sidelines at least until the uncertainty has lifted.

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Adria Cimino has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Nvidia. The Motley Fool has a disclosure policy.