Motley Fool Hidden Gems Investing - Is the Data Center Investing Trend in Trouble?

Starting point is 00:00:00 Is the data center investing trend in trouble? Motley Fool Hidden Gems Investing starts now. Welcome to Motley Fool Hidden Gems Investing. I'm your host, Jon Quast, and I'm joined today by Fool contributors, Matt Frankel and Lou Whiteman. Today, we're going to talk about the data center build out trend, and I promise that we're not going to regurgitate past talking points. There's going to be some new stuff here. But first, we wanted to talk about Snowflake. Snowflake has been a very popular stock among investors since it went public a number of years ago. It is over a $100 billion company, and today it is up more than 20%. It is hitting 52-week highs, and it is approaching all-time highs. Matt, we're going to let you talk to us here about

Starting point is 00:00:56 what is happening with Snowflake. Yeah, this is one I have to think that Berkshire Hathaway sold too early. They beat expectations pretty handily. Revenue growth was expected at 35%. It ended up 37%. They beat on the bottom line for the fifth consecutive quarter, massive guidance raise. And they posted a net revenue retention rate of 126%, which means that its customers are spending more and more as time goes on. That's a pretty remarkable rate. So not much to dislike about this quarter. Yeah, John, do we have to call Warren Buffett in and give him a lecture on day trading? Because, yeah, what's going on here, Warren? Why'd you get out? This has been just a weird stock, though, hasn't it? Even for tech stocks, it was a darling IPO in part because

Starting point is 00:01:44 it was the, Berkshire got in before the IPO, right? So it was the tech company that Warren Buffett endorsed. It fell nothing. I mean, it fell and did nothing for about three years and now it's great again. But then again, it's also barely back to its all-time highs from 2021. Just a really, really interesting company, but a heck of a quarter, not just a beaten raise, but a really aggressive raise. 36% revenue growth forecasted in fiscal 27. That's from a pretty good base to begin with definitely as ron gross would say firing on all cylinders well and yeah both of you are referencing why it has had such a weird publicly traded company arc berkshire hathaway warren buffett very much known for being tech averse and getting in on this company that a

Starting point is 00:02:36 lot of people didn't understand prior to the ipo and it was seen as a major stamp of approval here If the tech-averse investors are getting in on this, shouldn't I get in on this as well? Massive run-up prior to the IPO, and it is just kind of... I want to circle back to something that Lou just said here. It's kind of been a loser for many investors, depending on when you got in. This has been a loser stock. But you look at what it's done since going public, it routinely beats its revenue guidance. It routinely raises expectations. But it hasn't been a good performing stock for many investors. So what is different this time? Because we've beaten raised in the past, we're beating and raising now, and it's being celebrated. But what is really different

Starting point is 00:03:21 here, Matt? Yeah. So the price jump wasn't just because they beat expectations. Like you said, Snowflake regularly beats expectations. Five consecutive quarters of better than expected bottom line. It's because of the acceleration, really. So over the past three quarters, their top line growth has gone from 30 percent to 34 percent to 37 percent all ahead of expectations and q3 guidance and it implies even more acceleration going forward and not only that but margins improved while the growth accelerated faster than expected which is really impressive a lot of companies have this kind of acceleration right now but they're they're paying up for it adjusted operating margin came in at a little over 15 percent it was 11 percent a year ago

Starting point is 00:04:04 So not only is the growth accelerating, but so is the profitability. So that's really why you're seeing the stock up more than 20% today. Yeah, I wish I could jump in a DeLorean and invest just about two years ago because the stock is roughly quadrupled since its 2024 lows. And really, boys and girls, if you want to find a stock that can perform so well over a short time period, I mean, find a stock that is about to start accelerating revenue growth, one that's not doing it right now, but revenue growth is about to really pick up. That can often be something that is going to perform well. But Lou, let's talk about this acceleration

Starting point is 00:04:42 a little bit. I mean, it's not just that it's accelerating. Why is all of a sudden the gas pedal hitting the floor for Snowflake? Stop me if you heard this before, but AI, okay? And to be fair, you're right. There's been a lot of beaten raises where it didn't do much, but last quarter we saw a very similar beaten raise and I think even bigger jump versus the 20% today. So we're slowly catching on here, but like AI models thrive on data. That is the just foundation for all of these. Snowflake's core purpose is to make data accessible, to organize data and to make data available to humans, but also AI. So this is sort of a marriage made in heaven, I think. They took a lot of flack a few years ago. And one of the reasons the stock

Starting point is 00:05:26 went down was they switched from just a licensed model to a consumption model. So you only pay for what you use. And at the time, that drove revenue in the wrong direction, because instead of just paying a massive, huge, flat fee, companies could kind of cherry pick and only use it when they had to. But all of a sudden, AI workloads are coming in there and consumption-based model is really, really helping them, whether or not it's sustainable or temporary, we'll see, probably somewhere in the middle. But right now, paying for what you use in an environment where you desperately need to get data into your models is a very, very good model for Snowflake. Yeah, I would call out that management specifically said that AI workloads drove

Starting point is 00:06:07 roughly half of that growth acceleration we were talking about. So it is a major tailwind right now. And of course, Snowflake's Cocoa product, this is the coding agent. And basically you are able to incorporate your own data to write code for your own applications. That could be really powerful and continuing that acceleration. But we don't want to be just cheerleaders here on the sideline. We do want to talk about some things that maybe investors should take note of. Not necessarily, you know, absolute the sky is falling, but some things to watch that could be concerns down the road. We'll let Matt go first here. Yeah. So, I mean, there are a few things that I noticed. One that we talked about before we recorded their RPO, which is essentially their

Starting point is 00:06:50 backlog. It grew a little bit slower than revenue, but a lot of that seasonality, Snowflake pointed out that their renewals and things like that tend to happen in the fourth quarter. So I'm not paying too much attention to that. Valuation is obviously a concern. I've learned the lesson many times, as I know you have, that valuation always matters a little bit. Snowflake right now trades for about 20 times forward sales, about 80 times free cash flow. That's a lot, even with that growth. And stock-based compensation. There's a reason we're quoting things like adjusted EPS when we're talking about all this, because they are giving out a lot of stock to employees. Their stock-based compensation is almost 30% of revenue. That's a lot. That's down to their

Starting point is 00:07:34 credit from 39% a year ago. But their stock was diluted by more than 4% over the past year. And that's even with some buybacks intended to offset it. So that's one of my big concerns. Yeah, I'm glad you said that because, you know, look, it's part of life. We're used to it. But I am so frustrated by all this, you know, the way it's done. So I think that's definitely that evaluation. The other thing I'd mention is, is they did warn of some gross margin depression up ahead. The guidance was down 100 basis points. But look, the guidance was still for 74%. So those are decent margins. I don't want to play chicken little. Well, the bigger question, and this is sort of just the bigger picture question, we've heard about token maxing. We've heard about just like companies with just the kind of, that we're in the AI exploring mode and we seem to be moving towards an AI efficiency mode. So maybe there was a question on the call that is the, it's the customer just being

Starting point is 00:08:29 irrational now, or can this continue? And I think it's a decent question to ask. Is there a time that maybe the AI volumes get smarter instead of bigger and that consumption based model kind of comes back down to earth. It's still a good business if so, but back to Matt's point of valuation, there's a lot of the status quo continuing and going higher from here baked into that valuation. So any little flinch could cause trouble. After the break, we're going to be diving into data centers. You're listening to Motley Fool Hidden Gems Investing.

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Starting point is 00:09:54 flow and choose ginseng delight our new double espresso with ginseng extract whatever lies ahead don't change your morning. Let your morning change you. Discover Coffee Plus on Nespresso.com. Welcome back to Motley Fool Hidden Gems Investing. So we want to talk about data centers here. In July, New York became the first state to put a moratorium on new data centers and specifically for 50 megawatts and bigger. Now, if you're on a certain side of the political aisle, the political spectrum, you might look at a state such as New York, putting a moratorium on it and saying, well, that's what you'd expect with New York. But Texas now coming out and also putting a pause button on approvals because they're concerned about power and there's pushback

Starting point is 00:10:44 from communities. So here we have somebody on the red side of the spectrum and the blue side, and they're both hitting very big states, prominent states, and they're both hitting the pause button here on new data centers. Now, the president, of course, has stated his opinion that if you oppose AI progress, you're going to be backwards and poor. But, you know, we've been talking about this trend a lot because there's literally trillions of dollars pouring into the economy to build this out. That has resulted in many stock winners for us. And this data center boom, now there's pushbacks and questions about it. So we wanted to talk about that. What's going on and why is there pushback here, Matt? Yeah, well, I'm not surprised about this

Starting point is 00:11:25 statistic. 70% of Americans don't want data centers built near their homes. Now, I wouldn't want to look out my window. Right now, I see some nice palm trees, things like that. I wouldn't want to see a giant data center there. So I'm not shocked at that statistic. I was shocked to find out that there are 833 separate organizations that are specifically created in the United States to be opposed to data center construction right now. Now, opposition groups, these 833 groups in the first half of the year successfully blocked or delayed two out of every three data center projects they targeted. That surprised me. And that's something that investors should pay attention to. Okay. So Matt, give us an example here of a legitimate concern when it comes to

Starting point is 00:12:08 these data centers. Yeah. So you mentioned this is not a political issue, regardless of what side of the political spectrum you're on. Nobody likes higher power bills. Electric bills in the United States have risen about 5% on average over the past year, much higher in some areas, specifically the areas near data centers. And the massive power consumption by data centers is a big reason why. And they're expected to have a further 6% impact over the next year. Even most industry advocates like Greg Abel, Berkshire Hathaway's CEO, who Berkshire Hathaway Energy is a net beneficiary of you know he went on tv yesterday and said that the hyperscalers should absorb the power bills that these are causing and that's that is a big roadblock and a legitimate concern

Starting point is 00:12:50 yeah it's it's a weird moment now because i i don't want to make light of the concerns i think the concerns are serious and they need to be addressed but i also think these moratoriums are there's just a massive uneven power dynamic that what we're seeing right now between these big tech companies with their teams and teams of lawyers and small towns jurisdictions where a lot of the town council may be part-time workers who have like day jobs. That's going on. That's what's causing this moratorium. And I do think it's probably temporary. So, I mean, yeah, basically you're going up against a trillion dollar company and you're just this little tiny municipality and yeah, who pays for the power and you might have a hard time negotiating that.

Starting point is 00:13:37 But do you think, Lou, that we get past this pause? I mean, you've already alluded to it, but get things coming again? Well, here's the thing. I think the power dynamics should work the other way. They are desperate to get these things moving. I mean, look at what Meta, what Alphabet, what all these companies are spending to just try to go as quickly as they can. It feels like the towns, the municipalities, the states, they have more leverage than they

Starting point is 00:14:02 realize. So I do think this problem solves itself by saying, no, supply your own power or even contribute to our grid and bring power. The big thing now is, though, with these moratoriums, I think New York talked about it. Texas talked about it. Let's get these negotiated on the state level where it's kind of a more fight. You have the state lawyers, the state. You can't play towns against each other. You can't. We're not going to say what Shelbyville offered us, but it's really, really good. So doesn't Springfield want to get a good deal? That's the dynamics that have led to a lot of this anger and a lot of this just kind of the craziness going on. At a state level organized where everything is a little more transparent and you have just professionals negotiating with professionals who do this for a living, I think that that does end these moratoriums to get things going. And I do think the power dynamics might look a lot better for communities once we get there. Yeah, the tide of public opinion has definitely turned against these things right now. But Matt, I mean, are there some positives that we should consider when it comes to the data centers? Yeah, I mean, you mentioned the president's backwards and poor quote, which I mean, to unpack that more, he actually did mention some some very, you know, legitimate positives. Job creation is one that is building a massive data center in Louisiana right now. It has at peak construction, it's estimated to bring 7500 construction jobs, which are temporary, but this is going to be like an eight year project, as well as about 1000 permanent jobs to the area. So it does bring in jobs. It is a national security concern. and he mentioned China is laughing at us because this will help them in the AI race. He's not totally wrong. You know, maintaining a tech lead is a big part of national security. We have a whole national security portfolio at the full, and a lot of the stocks are focused on maintaining

Starting point is 00:15:44 our tech lead. And I mean, property taxes are another thing. I mentioned that metadata center. It is bringing in a roughly $30 million property tax bill to a parish in Louisiana whose tax receipts last year were 22 million dollars total so you know that's a big jump up in property taxes so there are some legitimate positives for these that and i mean he mentioned that these hyperscalers just need better pr to tell people why they should want this near them uh and and there are some legitimate reasons yeah so lou here talking about he believes that the pause the moratorium when it comes to data centers is temporary let's assume that lou is right here that the data center trend gets back on track. What about the stocks? Because as you mentioned, there are many stocks

Starting point is 00:16:30 in the Hidden Gems universe that are tied to this trend, and many of them are down right now. I look at Marvell down more than 30%. I look at Celestica down almost 40%. Sterling Infrastructure, one of the better performers among our stocks that we follow here, it's down more than 50% from its high. So do these stocks get back on track? It's complicated, okay? It's going to solve some of the problems, but it might not solve all the problems for these stocks. Depending on the company though, there are serious capacity constraints at work here too. It doesn't matter what your order book looks like if you only have so many employees or you only have so much manufacturing capacity, or there's only so much equipment available to be installed, even if you

Starting point is 00:17:13 have more demand. I both believe database construction will recover. And I do think that there's going to be some improvements for some of these companies. But I also think that the majority of the gains, there's the blockbuster gains for these suppliers, for these picks and shovels, they may be behind us. It's not a stir of gains now. It's about just kind of extending an elevated operating environment. I'd push back on that a little bit. I mean, Lou mentioned manufacturing capacity, employee capacity as constraints. There are others too. You know, there's power capacity, which we've talked about. That's why electric bills are going up. There's, uh, you know, uh, chip shortages, which, you know, you need chips to fill these

Starting point is 00:17:53 data centers. You need capital. Um, you know, NVIDIA just projected $1.3 trillion of hyperscale or CapEx next year. That's going to come from somewhere. And eventually the numbers get kind of too big and we're going to have some capital constraints. So we're seeing a lot of different constraints, I believe, priced into some of the stocks you mentioned. And now we have to worry about getting past zoning boards as well as another constraint. Um, so there's a, there are a lot of constraints in the industry. And I think, yes, the explosive gains, I don't think we're going to see, you know, Lumentum, for example, 10x again from here because of this. I think some of the big gains are behind us when it comes to some of these AI infrastructure companies. But I don't

Starting point is 00:18:31 think that, you know, we've seen them hit their all-time highs yet, for example. Well, one of our listeners is down big on an AI infrastructure stock. And after the break, we're going to take A question from them from our mailbag. You're listening to Motley Fool Hidden Gems and Busting. And what better way than with a delicious Pret Organic Coffee? Starting with just $1 all day, every day, now until December 31st. You gotta try breakfast at A&W. At participating A&W locations in Ontario.

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Starting point is 00:19:45 Whatever lies ahead, don't change your morning. Let your morning change you. Discover Coffee Plus on Nespresso.com. Welcome back to Motley Fool Hidden Gems Investing. And a quick note, we want to make you part of the conversation so you can send in questions to podcastatfool.com for any of our contributors here. We would love to take it if it's Foolish, if it's short enough to read on air, and if you keep in mind that we don't give personalized investing advice. And if you can check those boxes, then we'd love for you to email us at podcast at fool.com, podcast at fool.com.

Starting point is 00:20:20 And today's question comes from a listener named Ben. And Ben says that they heavily invested in a small cap AI infrastructure company and are currently sitting on a substantial unrealized loss. In other words, bought the stock and it went down pretty big. Despite that, I strongly believe the thesis and would invest the same amount at today's price. My bold case is that it could potentially return 10 to 15x by 2030. Alternatively, there's a much larger, more established company in the same ecosystem that I view as a relatively safer 2 to 3x over the same timeframe. So how should investors think about weighting that kind of asymmetric upside against the

Starting point is 00:21:04 greater certainty of the established company, especially when already sitting on a large loss? And guys, if I try to just think through this question, what's really being asked, this is almost more a question about portfolio construction. you have a riskier, higher upside, small cap company already sitting on the unrealized loss, a safer, less big upside from this other larger stock. And so how do we weigh that? Yeah. So not to pick on Ben because his email doesn't imply that this is hitting him, but I think it is. The first thing I think of this is the sunk cost fallacy. And I think it's

Starting point is 00:21:36 something we should all think about with these things. Sunk cost fallacy is our habit of staying committed to something because we've sunk resources into it, even if quitting is smarter. In this case, you know, we have invested all of this. We're down big. So it's harder to cut our losses. We should always make decisions based on our best judgment right now going forward. But when you're holding a large unrealized loss, there is a huge urge to, I just got to get back to even. So I do think that plays into here kind of some, as you're looking at this, it's hard to say apples to apples today. But to that question, how should investors think about slow and steady versus a high risk, high reward? It's a boring answer. I really do think it boils down to the individual, their risk tolerance, their goals, things like that. my answer for me is I'd probably do both. I'd probably say put 60% of the funds in an established company and the rest into a more speculative. So I get sort of the steady returns plus potential upside. But I really do think it depends on the circumstances and the individual and kind of what allows you to sleep at night. And just for our listeners, I want to point out

Starting point is 00:22:44 that Ben did not share the names of the two companies here. So Lou is not making a pick on either of those, just kind of generally saying, hey, this is how I would think about it if I was thinking through it like you are. But Matt, what do you have to add here? Yeah. So on the sunk cost fallacy thing, Ben passed the test on the main question you have to ask yourself. So he asked himself if he would buy more at today's price. And he specifically said that that answer is yes, I would invest more at today's price. And that's kind of the big kind of thing that Lou was talking about. The unrealized loss that you have is irrelevant to any forward-looking investment decisions, whether that is to exit or to buy more. The market doesn't know or care what your

Starting point is 00:23:21 cost basis is. That sounds silly to say, but many investors kind of subconsciously invest like it does. So I mostly agree with Lou about what he said with, you know, the steady, steady player versus the high risk candidate. I'd point out that, you know, he said, I see a two to three to X return potential by 2030 for even the slow and steady one, that translates to 17% to 29% annualized returns through 2030. That would still almost certainly be a market beater. So slow and steady in this case doesn't mean boring. It means that you see it has potential to beat the market still. So don't be afraid to put the majority into what you consider the safer play. If you're directionally right on the trend and buy it at a reasonable valuation, the return potential from

Starting point is 00:24:06 the safer of the two could still be pretty enormous. Yeah. And I mean, as you say, I mean, beating the market is hard to do. And if there's an option with a safe stock, I mean, that might not be a bad idea. So thanks to both of you for weighing in here. As always, people in the program may have interest in the stocks I talk about, and The Motley Fool may have formal recommendations for or against. So don't buy or sell stocks based solely on what you hear. All personal finance content follows Motley Fool editorial standards and is not approved by advertisers. Advertisements are sponsored content and provided for informational purposes only. To see our full advertising disclosure, please check out our show notes. Thanks to our producer Bart Shannon behind

Starting point is 00:24:45 the glass and the rest of the Motley Fool team. For Matt, Lou, and myself, thank you so much for listening to our show today, and we will see you again next time.

Motley Fool Hidden Gems Investing - Is the Data Center Investing Trend in Trouble?

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