Generative AI has taken the tech world by storm, led by the viral success of services like ChatGPT. Tech experts tout the technology as a game-changer, promising the ability to superpower the productivity of knowledge workers (think: white-collar jobs) around the globe. Semiconductor stocks in particular have been a top beneficiary, as these new AI systems need lots of expensive, cutting-edge chips to work.
Let's not leave Pure Storage (NYSE: PSTG) out of the conversation. The small digital data company continues to churn out steady growth since its 2015 initial public offering (IPO) but has largely gone unnoticed by many investors -- perhaps until now. In this era of AI, massive amounts of information are a necessity, and Pure Storage's business model may have solved for many of the pain points inherent in owning memory-chip and data-management hardware stocks. Here's what you need to know.
The solution for a big new problem
AI systems are big, complex, and expensive to develop and deploy. These software algorithms first need to be trained and then deployed (currently, primarily in a company-owned data center or public cloud provider) to operate. There are three primary ingredients in building these things:
- Computing: This involves chips that do the number crunching for AI training, chiefly from Nvidia as well as from myriad other chip designers for the inference (the AI product that does the work after it has been trained).
- Networking: To manage the massive flow of information needed for AI, advanced chips are needed to coordinate the movement of data; Broadcom and Marvell Technology Group are leading the charge here, with Nvidia also offering some solutions.
- Storage:Memory is also critical to AI as it is with any computing system, but AI requires an order of magnitude more data to be stored in order to train itself as well as for continuous operation of the AI system.
This last category -- storage -- may lead some investors to chip stocks like Micron Technology (NASDAQ: MU). Indeed, Micron itself has said that AI servers (the computers within data centers that perform AI operations) can require up to eight times more memory than a traditional server. That seems to bode well for Micron's long-term prospects.
But any memory-chip stock investor can tell you that this segment of the semiconductor industry is one of the most volatile. In boom times, not only do companies like Micron sell more chips, but pricing on those chips soar, which sends profitability sky-high. But on the flip side, when customer demand eases, chip prices and profitability plummet. It can be a gut-wrenching ride that many investors aren't comfortable with.
Data by YCharts.
Pure Storage's business model may present a solution: memory systems purchased as a service.
Pure Storage's win-win solution?
To be clear, Pure Storage sells memory systems for enterprises too, and it competes with companies like Hewlett Packard Enterprise, NetApp, and Dell Technologies. These data-storage sales can be highly cyclical, just like memory-chip sales.
But where Pure Storage really makes headway is in its subscription services, giving access to all sorts of digital memory systems with scalability, and ongoing hardware and performance upgrades built in. While stand-alone product sales are in a slump right now, along with much of the semiconductor industry, Pure Storage's subscription revenue keeps rising. Subscription revenue was up 28% year over year in the first quarter of fiscal 2024 (the three months ended in May 2023), continuing its strong run in this recurring-revenue department.
| FY20 | FY21 | FY22 | FY23 | Q1 FY24 | |
|---|---|---|---|---|---|
| Subscription revenue growth (YOY) | 43% | 33% | 37% | 30% | 28% |
| Subscriptions as a percent of overall revenue | 25% | 32% | 34% | 35% | 48% |
Data source: Pure Storage.
Pure Storage's solutions look like a win-win. Customers get more flexibility in how they handle their ever-increasing mountain of data, management of which is getting more critical in a new era of AI. And investors get access to a far more stable business model than the historic swings in demand inherent with memory chip companies and their more traditional enterprise-storage customers like HPE, NetApp, and Dell.
Of course, this theory needs to be tested out, because for all of its wild volatility, Micron stock has still been a better stock than Pure Storage since the latter went public in 2015.
Data by YCharts.
But small Pure Storage is growing up fast and constantly adding new products and performance features to its subscriptions. The company is consistently profitable on a free-cash-flow basis and could be poised to soar as data demand makes a big leap forward due to the AI boom. Pure Storage stock trades for just under 20 times trailing 12-month free cash flow. This one is on my watch list.
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Nicholas Rossolilloand his clients have positions in Broadcom, Marvell Technology, Micron Technology, and Nvidia. The Motley Fool has positions in and recommends NetApp and Nvidia. The Motley Fool recommends Broadcom and Marvell Technology. The Motley Fool has a disclosure policy.
