IT Consulting is Not Having a Good Time

0:02The SaaS apocalypse was the wrong apocalypse. Today on Motley Fool Hidden Gems Investing.

0:14welcome to motley fool hidden gems investing i'm your host tyler crow and today i'm joined by longtime fool contributors bat frankel and john quast so we're going to get into the kind of decline i guess if you will of the it services consulting industry over the past couple years based on accenture's earnings that were released earlier today and we're also going to do something a little bit different it's a special message from motley fool at the end here But we're going to start today with a recent report on how climate could be a much bigger factor for data centers than originally thought. Now, Matt, you originally brought this idea to the table with us.

0:50So what was the market missing about data centers that this report was bringing out? Yeah, so there's a study by First Street that was released today. It analyzed 97 different data center markets around the world. So the headline is that nearly 90 % of our global data center capacity today, not what's being built is at an elevated risk from climate-related hazards. Think flooding, think windstorms, wildfires. So most underwriting when you're buying insurance for real estate, it still uses historical data, which isn't doing a good job of predicting how climate events perform today. I know John lives in Florida.

1:24This is why a lot of insurers have exited Florida, because the past-looking data isn't doing a good job. So data centers are generally expected to operate for 20 to 30 years. So this could become a big problem, especially as we rely more heavily on data centers for all of our AI infrastructure needs. So some of the most exposed markets are international, like Asia Pacific is the worst. But Northern Virginia, which we would call the data center capital of the United States, has an above average level of exposure here. So here's the key takeaway. And this is confirmed by separate research, not just this study.

1:58So by 2030, more than half of data center hubs are going to find their water supplies stressed due to their cooling demand. Data centers produce a lot of heat. They actually create what are known as heat islands by warming the land around them by as much as 16 degrees in documented cases. Now, all of this can be mitigated at least on the building level. You could build buildings to be flood resistant. That's something that you see all the time in Florida. You can see power sources being upgraded. You can see cooling systems. But the stress on the supporting infrastructure, the power grids, the roads, the water supply in the local area.

2:32It's a real problem that's being overlooked. This is definitely a topic that's been bubbling up from time to time and kind of manifesting in various ways. And also not mentioned like in their report, and I think we've all hinting at it too, is that data centers are really expensive. And so the cost of these and getting them right makes a lot of sense. You know, you're saying flood resistant buildings and whatnot. But I'm thinking of like Meta's Hyperion Data Center, which is being built in like Northeast Louisiana, that's expected to be a$200 billion facility. And so, you know, if you have to insure a, you know, a warehouse, it's maybe a few million dollars.

3:12It's one thing, but$200 billion insurance or like trying to mitigate that risk when you're doing construction is a big deal because over the next 20, 30 years, who knows what's going to happen. So I have a two-part question for you both. Is there a specific part of the market within this AI infrastructure, data center build out that you see this report actually impacting? And then on a scale of one to 10, 10 being like the most actionable, how actionable is this to investing in that specific market? Well, let me just start with the one to 10 scale. In isolation, I would say this report from First Street is actionably a one.

3:53You know, I don't want to say that there's nothing wrong here with the climate whatsoever or anything wrong with the study, but let's be clear. First Watch, it's on a mission to connect climate and financial risks together. That's why it exists as a research firm. So it doesn't surprise me that it's sounding the alarm a little bit here on preparedness for climate risk. And some of the key constituents here would actually push back, including some of those who are building the data centers saying, we're very aware of the climate risks and we're already taking measures to counter those risks. So I don't think that there's anything really new here personally from the First Street Report.

4:36Now, that said, I mean, there is a huge buildout trend and there are lots of constraints that we're running up against. And it's not just climate related. I mean, you look at just the land issue that it takes. We need more data centers for AI, or at least they want to build more data centers for AI. Guess what? A lot of people are becoming increasingly uncomfortable with the land in their city, in their county being used for that purpose. Right or wrong, that is the perception that's growing. power is also something that's coming up against the wall even chips i think this is an interesting one there's some as far as how much compute we want to put in these data centers is taiwan semiconductor even capable of churning out that many right now elon musk would say no which is why he's investing in the tariff ab right and we need more and there's no player out there that can supply everything that we need so there are many constraints as far as actionability when it comes to that, I would say it's more of like a five.

5:36Yeah, there are a lot of constraints that are worth thinking about. I think that there's a place in your portfolio to think about smart use of limited resources. So in my portfolio, for example, I have Badger Meter. This is for water management. That to me just makes sense. We need to be smarter with our water and you can do that with the products and services that Badger Meter supplies. I can see a case for ITRON, which is more power management, stuff like that. But then, man, I also think about if we do run up against some walls here in the build-out, that is kind of an issue because there are some stretch valuations in the stock market.

6:12A slowdown in the build-out could impact those things. So just some things to keep an eye on. Yeah, so I would say the cooling solutions for data centers in particular are an excellent opportunity to invest in this right here. So Vertiv, ticker symbol is VRT. That's one of the most direct ways you can invest in this. They make power management systems, thermal management systems, and liquid cooling systems, all for data centers. It's already been one of the best performing AI infrastructure stocks in recent years, but the massive cooling needs, especially as, you know, from the climate related issues are not totally priced in yet.

6:46So I'm also at a five or so when it comes to actionability. And the reason is because the need for data center cooling was already an investable trend. This is not new because of a climate study. This is why stocks like Vertiv have performed so well. This certainly adds to the bull thesis, which is why I kind of split the difference with a five. I'm perplexed by this one too, because my immediate thought when I saw this was to that point about Meta and it's 200 billion, billion with a B facility. I started thinking about insurance because how the heck does a single insurance company insure a$200 billion building for something like flood insurance or hurricane insurance?

7:26from an actionability standpoint, I can see this being a huge risk and almost to my thing, it's like a six or a seven, but it's really hard for me to figure out specifically where that risk is located. I, you know, I'm not looking at like Berkshire Hathaway's Geico doing auto and home owner insurances. That's going to be, you know, an essential or existential risk for somebody like that. But there is somewhere along the chain of insurance that is going to be tied to these massive data center build out, probably somewhere in the excess and surplus industry. I don't know where it is, but I definitely want to go digging and find out.

8:05Coming up over the break, we're going to talk about IT consultancies and why they're doing so lousy lately.

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8:49All investments involve risk, including the potential loss of principle. Past performance is not indicative of future results. This is a paid advertisement. Now, we talked a little bit about the SaaSpocalypse, where AI is going to eat anything software. And maybe some of that's a little overblown. Maybe some are going to do well, some are going to fail. But one place that I think is getting not nearly as much conversation related to the doom and gloom is the IT consultancy and IT services industry, because this is an industry that's hurting even worse. And just as an example, shares of Accenture are down about 17 % today as we're taping after the company reported its fiscal third quarter results.

9:28It was a story that we heard quite a bit. Numbers for the quarter look relatively fine, but it's the things that didn't really get said that had everyone worried. That's what I think we saw, right, Matt? Yeah, I mean, as you said, the numbers look fine, and that's a good word for it. Revenue was up 6 % year-over-year, basically in line with estimates. Earnings were 9%, slightly beat estimates. Operating margins showed a pretty solid improvement. And to be fair, management's showing really good cost discipline. That's why margins are growing. That's why earnings are growing faster than revenue.

9:58But revenue guidance was narrowed to 3 % to 4 % for the full year from previous range of 3 % to 5%, so slightly lowered. There's no more surefire way to make a stock go down than to lower your guidance. Earnings growth is supposed to be about 10 % to 11 % for the year. It's fine, but nothing to get excited about. The guidance, like I said, is the biggest drag on the stock. Three to four percent earnings growth, quite frankly, doesn't justify much more than the 13 times earnings it's trading at after this drop. Yeah, the salespocalypse has been a topic that's often covered in financial media. And certainly we've dipped our toes into it from time to time.

10:33It makes for pretty good chatter. And at the same time, there's a lot of people who have stocks in the salespocalypse kind of trade that have not done so well recently. Now, a thesis has kind of had mixed results so far. What we haven't probably spent enough time is on this IT consultancy apocalypse. Over the past decade, shares of Accenture are up a meager 32%. And that's after probably almost a 50 % drop from their highs. And Accenture is one of the best performing IT consultancies over that time. You look at companies like Globant or EXL Services, these are all companies that are doing far worse.

11:08and it's really impacting not just like any single company, but anybody who's invested in this industry is really hurting. Yeah, and I mean, Tyler, we've sold some of those in our hidden gem services throughout the Fool and for that reason, because it's an undercovered story, but it is really hurting lately. And I mean, on the other side of it, we've added some stocks that have IT consultancy businesses, but do a lot of other things that are getting ahead of the AI curve. I'm going to mention one of those in just a minute. but it's you know we have been kind of we've been seeing this for a while now yeah and this is a i feel like a quandary for most investors because so far the financial numbers for all of these mentioned it services companies are they're still okay revenue still growing it's not as good as it was but i wouldn't say like five alarm fire sort of things and a lot of the stock decline has been basically drastic changes in march market sentiment and stock valuation resets so i want to get both of your opinions on this one.

12:06And John, I'm going to go to you first. At these valuations, deeply depressed stock prices, is there a company in this industry that's worth considering? Or based on what you've seen from AI and some of the threats we've seen recently, is this just like a no-go area until they can figure out how to compete or build businesses that are more complementary to AI? Yeah, for me, the IT space is completely uninvestable right now. It's a no-go. Now, that said, I mean, it's just a space that's going to be full of losers, I think. Now, not to say there's not going to be any winners in the space, but I just prefer to avoid the entire space because there are so many landmines out there.

12:44You mentioned that the numbers are still okay, and that is a good point. But the counterpoint to that is we do want to sell our businesses before the numbers turn bad, right? And so if we have a reasonable suspicion that the numbers could turn negative in the future, then we kind of want to get out in front of that before it actually manifests. Because at that point, the stock is probably going to be even down more than it is right now. As we look out in the IT space, I do think that this kind of a business gets tougher the further I look out. And there's reasons for this. I do think that personalized advice from a human person is a dying art form.

13:23And for better or for worse, I would personally say probably a little bit more towards the worst, but it is being replaced by AI, this personalized input into your business, into your life. AI is doing that more and more than a human. I think that you could make the argument that ChatGPT is already the world's largest mental health services provider. We could say you shouldn't be going to ChatGPT for mental health assistance. Maybe that's right, but people are. And that's the point here. And think about somebody like Tim Ferriss recently coming out. This is the author of the four-hour work week, recently coming out and saying that his sales in 2026 are trending 80 % lower than in 2022 based on the data he has so far.

14:06And that is a very steep 50 or greater than 50 % drop-off this year in his sales compared to last year. And last year was another huge drop-off. So increasingly, you're seeing where somebody would have gone to a book like that before and said, how can I personalize this for me? Now, just going straight to the AI and saying, how can you personalize this concept for me? And it does it for you. And we kind of have this sense that AI knows me better, that it can personalize it better, that we can even guide it to tell us a little bit what we want. And I think that that's what we're all looking for, whether we like to admit it or not.

14:41Whereas a person might tell you something you don't want to hear. So we are doing this more and more. I think the business space is happening more and more that way. Businesses were maybe going to Accenture to get advice on how to implement AI. And now you can really just ask AI how to implement itself. Yeah. So, I mean, if you believe that Accenture's revenue is going to stabilize at that 3 % to 5 % long-term growth rate, it could be a solid value here. I mean, you'll get a nearly 4 % dividend yield while you wait. The business produces over$10 billion of free cash flow a year and you're getting it at a low double digit earnings multiple.

15:16So I'm not buying it, but, but it, you know, there could be value there. One that is on my radar and it's the most recent position I bought in my portfolio is IBM. They have an IT consulting business that, you know, they consider kind of their legacy business. It's, it's been under pressure just like Accenture's, but they also have their infrastructure business, their mainstream business or mainframe business, their software business. And there are several areas of their business, including those where AI adoption is actually a major tailwind. So whenever you have an industry that's in the midst of disruption and uncertainty, I like to look for companies that do a lot of other things well too.

15:51The recent Confluent acquisition certainly moves IBM further from relying on their legacy revenue streams. Management is also doing a great job of being on the forefront of new trends. I can't name a publicly traded company that's further along in quantum computing, just to name one example. So IBM is the way I would play the space right now, and I have, but I wouldn't be buying Accenture or any of the other pure plays. To circle back what Matt was saying about Accenture possibly being a value here, or at least laying out that it does make a little bit of sense from a value perspective. And if you're in that camp, just keep in mind a few things with Accenture, announcing over$4 billion in cybersecurity acquisitions today, and the acquired businesses don't earn a profit.

16:33So when you think about the future earnings of Accenture, they're going to come down more than likely, at least temporarily, while these things scale. Also, the acquisitions it made at 20 times enterprise value to annual recurring revenue, that's not exactly cheap. So the perceived value with Accenture, just be careful when you're looking at those backward-looking metrics. It might not be quite the value that it seems to be, and the acquisitions that it's making kind of aggressively are what is going to cause the future value. Well, certainly the outlook for these is probably one of the less certain times we've seen in the IT consulting services.

17:11So we're gonna do something a little bit differently in the next segment, and it's actually just gonna be me. So I want to say thank you to John and Matt before we go off to the break. We'll talk to you guys this time next week.

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21:21All personal finance content follows Motley Fool editorial standards and is not approved by advertisers. Advertisements are sponsored content and provide for informational purposes only. To see our full advertising disclosure, please check out our show notes. Thanks for producer Bart Shen and the rest of The Motley Fool team. For Matt, John, and myself, thanks for listening, and we'll chat again soon. Thank you.