Is the Data Center Investing Trend in Trouble?

0:03Matt Frankel:Is the data center investing trend in trouble? Motley Fool Hidden Gems Investing starts now.

0:13Matt Frankel: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 what is happening with Snowflake?

0:58Jon Quast: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.

1:30Lou Whiteman: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 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.

2:08Lou Whiteman: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.

2:20Matt Frankel: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 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.

3:00Matt Frankel:But you look at what it's done since going public, it routinely beats its revenue guidance. It routinely raises expectations. And so, but it hasn't been a good performing stock for many investors. So what is different this time? Because we've beaten and raised in the past. We're beating and raising now and it's being celebrated. But what is really different here, Matt?

3:22Jon Quast: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 % to 34 % to 37%, 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 paying up for it.

3:59Jon Quast: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.

4:13Matt Frankel:Yeah, I wish I could jump in a DeLorean and invest just about two years ago because the stock has 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?

4:49Lou Whiteman: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 went down was they switched from just a licensed model to a consumption model.

5:30Lou Whiteman: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.

6:03Jon Quast: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.

6:12Matt Frankel: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 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. 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.

6:42Jon Quast: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 they're you know they're they're 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 um i i've learned the lesson many times as i know you have that valuation always matters a little bit um snowflake right now trades for about 20 times forward sales about 80 times free cash flow that's a lot even with that growth um and stock-based compensation.

7:20Jon Quast: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.

7:46Lou Whiteman: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. 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, we just kind of that we're in the AI exploring mode and we seem to be moving towards an AI efficiency mode.

8:25Lou Whiteman:So maybe there was a question on the call that is the customer just being 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.

8:54Matt Frankel: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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10:25Matt Frankel: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 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.

11:14Matt Frankel:Now, the president, of course, has stated his opinion that if you oppose AI progress, you're going to be backwards and poor. But 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 is going on and why is there pushback here, Matt?

11:40Jon Quast:Yeah, 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 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.

12:16Jon Quast:That surprised me. And that's something that investors should pay attention to. Okay.

12:21Matt Frankel:So Matt, give us an example here of a legitimate concern when it comes to these data centers.

12:26Jon Quast: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 CEO, who Berkshire Hathaway Energy is a net beneficiary of this. You know, he went on TV yesterday and said that the hyperscalers should absorb the power bills that these are causing.

13:05Jon Quast:And that's that is a big roadblock and a legitimate concern.

13:09Lou Whiteman:Yeah, it's a weird moment now because 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 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 look 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.

13:44Matt Frankel: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. But do you think, Lou, that we get past this pause? I mean, you've already alluded to it, but get things coming again?

14:02Lou Whiteman: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 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.

14:37Lou Whiteman: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? 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 I think that that does end these moratoriums to get things going. And I do think the power autonomous might look a lot better for communities once we get.

15:13Matt Frankel: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?

15:21Jon Quast: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. Matt 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 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.

15:52Jon Quast:He's not totally wrong. Maintaining a tech lead is a big part of national security. We have a whole national security portfolio at the Fool, 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. So there are some legitimate positives for these. And I mean, he mentioned that these hyperscalers just need better PR to tell people why they should want this near them.

16:29Jon Quast:And there are some legitimate reasons. Yeah.

16:32Matt Frankel: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%. 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?

17:09Lou Whiteman:It's complicated, okay? It's gonna 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 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.

17:49Lou Whiteman:It's not a sort of gains now. It's about just kind of extending an elevated operating environment.