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

Starting point is 00:00:03 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, John Kwas, 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.

Starting point is 00:00:31 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 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 was it ended up 37. They beat on the bottom line for the fifth consecutive quarter, massive guidance raise.

Starting point is 00:01:15 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 my lecture on day trading? Because, yeah, what's going on here, Warren? No, why did you get out? But this has been just a weird stock, though, hasn't it?

Starting point is 00:01:41 Even for tech stocks, it was a darling IPO in part because 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.

Starting point is 00:02:15 That's from a pretty good base to begin with. Definitely, as Ron Gross would say, firing on all cylinder. 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 lot of people didn't understand prior to the IPO and it was seen as a major stamp of approval here. Like if the tech averse investors are getting in on this, shouldn't I get in on this as well? Massive run up prior to

Starting point is 00:02:49 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 here, Matt? Yeah. So the price jump wasn't just because they beat expectations. Like you said, Snowflake regularly beats expectations. consecutive quarters of better than expected bottom line. It's because of the acceleration, really.

Starting point is 00:03:35 So over the past three quarters, their top line growth has gone from 30% to 34% to 37% all ahead of expectations. And Q3 guidance, 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 paying up for it. adjusted operating margin came in at a little over 15%. It was 11% a year ago. 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.

Starting point is 00:04:13 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 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?

Starting point is 00:04:49 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.

Starting point is 00:05:18 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 went down was they switched from just a license 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 be able, we'll see, probably somewhere in the middle.

Starting point is 00:05:54 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 roughly half of that growth acceleration we were talking about. So it is a major tailwind right now. And of course, Snowflake's COCO 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 in 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,

Starting point is 00:06:34 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 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

Starting point is 00:07:01 too much attention to that. Valuation is obviously a concern. I've learned a 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 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,

Starting point is 00:07:48 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 infalluation. 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. 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 that just, they kind of, the, 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 about is it's the customer just being irrational now,

Starting point is 00:08:30 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.

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Starting point is 00:10:01 Find the 100th anniversary of the Royal Canadian Legion $2 coin today. 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 site, 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.

Starting point is 00:10:34 But Texas now coming out and also putting a pause button on approvals because they're concerned about power and there's pushback 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,

Starting point is 00:11:19 we wanted to talk about that. What's going on and why is there pushback here, Matt? Well, I'm not surprised about this statistic. 70% of Americans don't want data centers built near their homes. Now, I wouldn't want to look at 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

Starting point is 00:11:41 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 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

Starting point is 00:12:19 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 this. 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 road. lock and a legitimate concern. Yeah, it's, it's a weird moment now because I don't want to make light of the concerns.

Starting point is 00:12:56 I think the concerns are serious and they need to be addressed. But I also think these moratoriums are temporary. 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 law and small towns jurisdictions where a lot of the, a lot of the town council may be part-time workers who have like day job. 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, this pause? I mean, you've already alluded to it, but get things something again? Well, here's the thing. I think the power dynamics should work the other. They are desperate to get these things in the 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, and states, they have more leverage and they realize. So I do think this problem solves itself by saying,

Starting point is 00:14:05 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 say, we're not going to say what Shelbyville offered us,

Starting point is 00:14:28 but it's really, really good. So doesn't Springfield want to get a good fight? That's the dynamics that have led to a lot of this anger and a lot of this just kind of the craziness. 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 lot. I think that that does end these moratorium to get things going.

Starting point is 00:14:50 And I do think the paradigmists might look a lot better for communities once we get. 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 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 7,500 construction jobs, which are temporary, but this is going to be like an eight-year project, as well as about a thousand permanent

Starting point is 00:15:26 jobs to the area. So it does bring in jobs. It is a national security concern. 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 our tech lead. And, I mean, property taxes are another thing. I mentioned that Meta Data 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 total. So, you know, that's a big jump up in property taxes.

Starting point is 00:16:01 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. 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 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%.

Starting point is 00:16:38 I look at Celestica, down almost 40%. Sterling infrastructure, one of the better performers in among our stocks that we, 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. It 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 have more demand, I both believe database construction

Starting point is 00:17:17 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 bit of a start of gains now. It's about just kind of extending an elevated operating environment. I push back on that a little bit. I mean, Lou mentioned manufacturing capacity, employee capacity is as constraints. There are others, too. You know, there's power capacity, which we've talked about.

Starting point is 00:17:47 That's why electric bills are going up. There's, you know, chip shortages, which, you know, you need chips to fill these data centers. You need capital. 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,

Starting point is 00:18:08 priced into some of the stocks you mentioned. And now we have to worry about getting past zoning boards as well as another constraint. So 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, momentum, 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.

Starting point is 00:18:30 But I don't 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 mailback. You're listening to Motley Fool Hidden Gems Investing. Two and five Canadians will hear the words, you have cancer. That's why every step and dollar raised matters. On September 19th, join thousands in Toronto for the Princess Margaret Cancer Foundation Walk.

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Starting point is 00:19:42 Our new double espresso with ginseng extract. Whatever lies ahead, don't change your morning. Let your morning change you. Discover coffee plus on espresso.com. Welcome back to Motley Fool Hidden Gems Investing. In a quick note, we want to make you part of the conversation so you can send in questions to podcast at fool.com for any of our contributors here.

Starting point is 00:20:05 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. And today's question comes from a listener named Ben. And Ben says that they heavily invested in a small-cap AI infrastructure company

Starting point is 00:20:29 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 wading that kind of asymmetric upside against the greater certainty of the established company, especially when already sitting on a large loss.

Starting point is 00:21:09 And as 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 something we should all think about with these things. Sun cost fallacy is our habit of staying committed to something because we've sunk resources into it, even if quitting is smarter.

Starting point is 00:21:45 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 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.

Starting point is 00:22:25 I'd probably say put 60% of 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 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.

Starting point is 00:22:56 So on the sun cost fallacy thing, Ben passed the test on, 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 answers, 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.

Starting point is 00:23:19 The market doesn't know or care what your 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 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 feeder.

Starting point is 00:23:51 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 can. consider the safer play. If you're directionally right on the trend and buy it at a reasonable valuation, to return potential from 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

Starting point is 00:24:23 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 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 Money - Is the Data Center Investing Trend in Trouble?

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