SMART Global Holdings: Expectations Reset A Good Thing (NASDAQ:SGH)

The market certainly did not like what SMART Global Holdings (NASDAQ:SGH) had to say in its Q1 FY2022 earnings report. The stock was rallying until the Q1 report stopped it dead in its tracks, triggering a major decline and coming close to wiping out the preceding rally that followed the Q4 FY2021 report. However, the stock has rebounded in recent days after encountering what looks like support, suggesting the worst may have passed. In addition, there’s reason to think the market may have overreacted to the Q1 report. SGH is not as bad off and a recovery may not be so far away. Why will be covered next.

Earnings reports have shown the way for SGH

Earnings reports make a difference, something SGH can agree with after its recent experience. The Q4 FY2021 report triggered a rally in the stock and the Q1 FY2022 report triggered a selloff. The stock gained 66% in the weeks and months following the release of the Q4 FY2021 report and the stock has lost 29% following the Q1 FY2022 report, wiping out most of the preceding rally as shown below. The stock is down 27% YTD in 2022.

However, the stock has shown signs of life, having bounced in recent days. Moreover, the reversal happened at a known support level, around $25, which is an area where the stock has found support before on several occasions. In fact, $25 is an area where the stock has changed course several times in recent years. It has served as an area of support, but also as resistance as shown in the chart below.

The stock has not breached the lower trendline going back to last year with the recent rebound, although that does not mean it cannot happen on a subsequent attempt. Still, the stock appears to have found some support. The most recent low is higher than the preceding ones, a positive sign, suggesting the overall trend remains up for SGH.

Why the market did not like the Q1 FY2022 report from SGH

The Q1 report was not a complete washout. It actually contained a number of positives. For instance, Q1 revenue increased by 61.1% YoY to $469.9M, which is a new all-time high. Non-GAAP gross margin was a record 27%, up 850 basis points YoY. GAAP EPS increased by 812.5% YoY to $0.73 and non-GAAP EPS increased by 176.9% YoY to $2.16, equaling the record high set in the preceding quarter. Adjusted EBITDA was $76.7M in Q1 FY2022, up from $29.5M in Q1 FY2021.

GAAP earnings fell way short of guidance in Q1 FY2022, but the non-GAAP number surpassed expectations. It appears the former was weighed down by acquisition-related charges. Remember that SGH acquired the LED unit from Cree, or Wolfspeed (WOLF) as the company is now known, and that acquisition is still filtering through the quarterly numbers. The non-GAAP numbers tend to do a better job of filtering out the noise caused by acquisitions and related gains or losses. The table below shows the numbers for Q1 FY2022.

(GAAP)	Q1 FY2022	Q4 FY2021	Q1 FY2021	QoQ	YoY
Revenue	$469.944M	$467.709M	$291.697M	0.48%	61.11%
Gross margin	26.0%	25.2%	18.0%	80bps	800bps
Operating margin	7.4%	6.8%	2.6%	60bps	480bps
Income from operations	$34.794M	$31.739M	$7.624M	9.63%	356.37%
Net income (attributable to SGH)	$20.027M	$20.652M	$2.027M	(3.03%)	888.01%
EPS	$0.73	$0.78	$0.08	(6.41%)	812.50%
(Non-GAAP)
Revenue	$469.944M	$467.709M	$291.697M	0.48%	61.11%
Gross margin	27.0%	26.4%	18.5%	60bps	850bps
Operating margin	14.7%	14.2%	8.1%	50bps	660bps
Income from operations	$69.150M	$66.589M	$23.742M	3.85%	191.26%
Net income (attributable to SGH)	$56.308M	$55.138M	$19.629M	2.12%	186.86%
EPS	$2.16	$2.16	$0.78	–	176.92%

Source: SGH Form 8-K

Q1 revenue increased by 61%, but the YoY increase would have been 23% without the LED unit. The table below breaks down Q1 revenue. In terms of end markets, mobile & PCs was 21%, network & telecom was 10%, servers & storage was 12%, AI, data analytics & machine learning was 15%, advanced lighting was 24% and industrial, defense & other was 18%.

The Memory business would have grown by about 20% and not 6% if SGH had not decided to reclassify customer revenue from a gross to a net basis as elaborated on in a prior earnings call. IPS was the standout, growing 80% YoY to a record $118.7M. The LED unit contributed $111.9M, up from nothing a year a go.

(Unit: $1000)	Q1 FY2022	Q1 FY2021	YoY
Intelligent Platform Solutions	118,654	65,874	80.12%
Memory Solutions	239,401	225,823	6.01%
LED Solutions	111,889	–	–
Total	469,944	291,697	61.11%

The Q1 numbers were strong, leaving no doubt that SGH has advanced a great deal in the last twelve months. However, guidance was something else. Guidance calls for Q2 FY2022 revenue of $415-455M, an increase of 43% YoY at the midpoint. The forecast sees GAAP EPS of $0.55-0.85, an increase of 204.4% YoY at the midpoint, and non-GAAP EPS of $1.30-1.60, an increase of 66.7% YoY at the midpoint.

On the other hand, the top and the bottom line are both expected to decline sequentially. Revenue will decline by 7.44% QoQ and non-GAAP EPS by a hefty 32.9% QoQ. Margins are also expected to shrink QoQ. The decline is due to seasonality in the LED unit and quarter-to-quarter variability of the IPS unit. Note that guidance does not account for the 2 for 1 share split.

(GAAP)	Q2 FY2022 (guidance)	Q2 FY2021	YoY (midpoint)
Revenue	$415-455M	$304.0M	43.09%
Gross margin	23-25%	17.6%	640bps
EPS	$0.55-0.85	$0.23	204.35%
(Non-GAAP)
Revenue	$415-455M	$304.0M	43.09%
Gross margin	24-26%	19.5%	550bps
EPS	$1.30-1.60	$0.87	66.67%

Why guidance is not as worrisome as it appears to be

The market obviously did not like a shrinking top and bottom line, judging by the price action following the release of the Q1 report. Furthermore, sentiment towards SGH seems to have shifted. Pessimism has jumped. For instance, short interest is now more than double what it was before the Q1 report.

The decline in the IPS unit was a surprise after the strength it showed in previous quarters. Management added some color as to why the IPS unit would take what looks like a step back. From the Q1 earnings call:

“there will be variability, specifically as it relates to the IPS business and the margin profile quarter-to-quarter. You’ve seen that as we’ve migrated from Q1 and towards our guide in Q2, that there is some variability in the overall gross margins which then impact the operating margins. But overall, business is tremendously healthy if you look at where we are today versus just 12 months ago in terms of both the gross margin profile and the operating margin profile of the business”

A transcript of the Q1 FY2022 earnings call can be found here.

A previous article pointed out that revenue, margins and earnings can vary from quarter to quarter in IPS due to the timing of the deployment of hardware, software, and managed services in any given quarter. Timing was on the side of SGH in Q4 FY2021, which in turn boosted earnings for that quarter, triggering the rally in the stock. However, the article cautioned that timing may not necessarily be so favorable again in following quarters.

This warning turned out to be prescient, because that’s exactly what happened to SGH in Q1 FY2022. Guidance was a letdown due to Q2 FY2022 not being as heavy on services that helped margins and by extension earnings in other quarters. Q2 FY2022 looks to be weighted towards hardware deployment and less so towards services.

The good news is that things should change in the coming quarters. Once hardware installations are done, services should follow. With this in mind, the second half of FY2022 is likely to be better. The timing of deployments should turn in favor once again of SGH, which means longs need to be patient and wait it out. At the end of the day, SGH is moving in the right direction as shown in the YoY improvements, temporary fluctuations from quarter to quarter notwithstanding.

SGH is relatively inexpensive

SGH has encountered a rough patch in terms of revenue and earnings growth, but there’s reason to believe improvement is not that far away. Getting in now that the stock is down could pay off later. In addition, valuations are such that placing a bet on SGH does not have to cost an arm and a leg. The table below shows the multiples SGH trades at.

	SGH
Market cap	$1.30B
Enterprise value	$1.48B
Revenue (“ttm”)	$1,679.4M
EBITDA	$203.0M
Trailing P/E	35.25
Forward P/E	14.98
PEG	0.01
P/S	0.76
P/B	4.02
EV/sales	0.88
Trailing EV/EBITDA	7.28
Forward EV/EBITDA	5.65

Source: SeekingAlpha

For instance, SGH has an enterprise value of $1.48B, which is equal to 7.28 times EBITDA on a trailing basis and 5.65 times EBITDA on a forward basis. In comparison, the sector median is 16 and 13 respectively. SGH trades at significantly lower multiples than most, with the notable exception of price-to-book, which is in line with the average.

Investor takeaways

The latest guidance has taken the wind out of SGH’s sails. Revenue and earnings jumped in the last three quarters, thanks in part to acquisitions, but they’re expected to shrink in Q2. The stock has given back much of what it gained following the second-to-last earnings report. The stock is basically back to square one. The selloff following the Q1 FY2022 report has effectively negated the rally following the Q4 FY2021 report.

However, the market may have overreacted to guidance. It’s true non-GAAP EPS is expected to fall by roughly a third, but that’s mostly due to temporary factors that should straighten out by themselves. Seasonality changes automatically. Hardware deployments will open the door for more services. The second half of FY2022 should be better than Q2. Bulls should not be overly concerned by Q2 guidance. SGH has improved greatly in recent quarters and that trend remains intact.

I am bullish SGH. The recent decline in the stock has brought down expectations, which could be a good thing since it paves the way for SGH to beat in the coming quarters. Q2 guidance looks to be an aberration. Now may be a good time to get in on SGH with the stock down, with multiples where they are and with the stock having found what could be strong support. SGH is down, but odds are, it won’t stay that way.