Super Micro Computer Stock Looked Like It Could Be a Good Buy, Until I Saw This Number

Super Micro Computer (NASDAQ: SMCI), better known as Supermicro, has benefited from rising demand for its data center servers in recent years as the artificial intelligence (AI) trend has driven a massive buildout of cloud infrastructure. The company's growth has been impressive. Over its past four reported quarters, it has generated more than $21 billion in sales. Only a few years ago, it was bringing in less than $6 billion in annual revenue.

Further, it looks poised for more growth as spending on AI hardware remains robust. Heading into this year, the tech stock looked like it might be an underrated option for AI investors to load up on, given its relatively modest size; its market cap is currently below $20 billion. But there's an important metric for investors to consider before deciding whether or not to invest in this company: its gross margin.

Image source: Getty Images.

A narrow gross profit margin

According to analysts' consensus estimates, Supermicro's gross profit margin is expected to be around just 7.5% this year. Back in 2022, it was more than twice that.

This is a big problem for the company. Nearly 93% of its revenues are going to cover its cost of goods sold, and what's left has to cover its overhead and operating expenses. Low-margin businesses need to generate extremely high volumes to be meaningfully profitable. A 7.5% gross margin is more the type of level one might expect from a retailer or a supermarket chain. Based on these figures, Supermicro might not be able to improve its bottom line much, even if it achieves significant top-line growth.

Narrow margins also leave little room for error. Keeping a sharp focus on cost management is imperative. Without it, earnings could easily deteriorate.

So even though high demand for its AI servers presents Supermicro with an opportunity for serious sales growth, that might not necessarily result in much stronger profit numbers.

Supermicro's forward earnings valuation looks appealing... for now

Supermicro stock trades at a forward price-to-earnings multiple of less than 17 -- a level that might tempt you to buy it. However, that metric is, of course, based on estimated profits. If spending on AI servers slows down, and if the company's poor margins result in it booking only minimal bottom-line growth, analysts may well adjust their expectations for the business accordingly, and that forward earnings multiple may suddenly get a lot higher.

Though Supermicro appears positioned to keep benefiting from the growth in AI, investors should always tread carefully with businesses that are generating low margins. What's worse is that in this case, those margins are expected to contract even further. Low margins alone would be enough of a reason to tread carefully with this AI stock; declining low margins make it one to avoid altogether.

David Jagielski, CPA has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.