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Vertiv Holdings Llc.(VRT-N)

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Be Careful Chasing This Booming AI Stock

Motley Fool - Mon Aug 28, 2023

With Nvidia's (NASDAQ: NVDA) terrific earnings report and guidance last Wednesday, investors may be looking for other stocks that will benefit from the buildout of artificial intelligence infrastructure.

One under-the-radar name is Vertiv(NYSE: VRT), a provider of data center rack systems, power management, switchgear, and thermal heat control systems.

Those services will see big demand in the age of AI, as leading-edge AI semiconductor systems require a huge amount of electricity and also generate excess heat. In fact, investors are so bullish on Vertiv, it even outperformed the Nvidia over the trailing 12 months, tripling in that time:

VRT Chart

VRT data by YCharts

However, while I think Nvidia is still a good hold here, investors may want to temper their expectations for Vertiv, for the following reasons.

Recent growth the result of price increases

Last quarter, Vertiv handily outperformed expectations, with revenue growth of 24% and adjusted operating margin increasing a whopping 860 basis points to 14.5%, a massive upward inflection in profit. Management also raised full-year revenue guidance by $285 million to $6.81 billion and increased its adjusted free cash flow guidance by $200 million to $550 million -- quite a big leap.

These were certainly impressive results, but investors should know that 9% of the 24% revenue gains were from price increases. Meanwhile, the massive operating profit increase was mostly driven by both price increases in combination with lower-than-expected cost inflation, such as materials and freight. So Vertiv was essentially raising prices to catch up with last year's inflation, as costs came in below expectations.

While 15% to 16% volume growth is impressive, it's probably unlikely the company will be able to increase pricing that much next year, especially if costs keep falling. While Vertiv's solutions are definitely in demand, Vertiv has well-funded competitors in data center management, and its technology doesn't have the differentiated moat that, say, Nvidia has.

So the mid-teens growth rate is probably more the business' underlying Q2 growth rate. That's certainly nothing to sneeze at, but it's a bit different from the headline mid-20s headline rate. Vertiv should see some incremental growth from AI, but unless it displaces competitors, it's hard to know exactly how much incremental growth will come its way.

Valuation is getting fair

Mid-teens growth is very solid, but remember, this was a quarter in which companies saw massive demand for AI data centers, which rely heavily on power and thermal management. And the company's valuation has expanded to 26 times this year's upwardly revised free cash flow guidance. That's not that cheap, especially with bond yields and interest rates continuing to rise.

Vertiv also has a significant amount of debt, which stood at around $3 billion at the end of last quarter, against just $275 million in cash. Vertiv should continue paying that down this year, but it will take a bit of time to de-lever. The company noted that current leverage is at 3.1 times adjusted EBITDA (earnings before interest, taxes, depreciation and amortization), but that it should go down to 2.3 times EBITDA by year's end.

Again, this is all good stuff, but enough to justify a forward price-to-free cash flow multiple in the upper 20s? Probably not.

Large data center with technician standing with laptop.

Image source: Getty Images.

Insiders just sold a bunch of stock

Finally, Vertiv shareholders should know that its largest shareholder just sold a little more than half its shares earlier this month, and below the current stock price.

On Aug. 9, VPE Holdings sold 20 million shares at an agreed-upon discount that amounted to a stock price just under $35. Today, Vertiv's stock price is a bit higher, at $37.50. Of note, this is just a little bit more than half of VPE's holdings, which totaled 38 million shares as of the company's proxy statement in April.

It might not be a huge warning that VPE decided to take profits. After all, VPE was the parent company that brought Vertiv public through a special-purpose acquisition company (SPAC) in early 2020. SPACs usually come to market at $10 per share, so selling at $35 means VPE has made a nice 250% gain in just three and a half years.

In that light, for VPE Holdings to sell more than half of its stock to lock in profits is not that surprising, and it's probably not a warning of a big imminent drop. However, it's also an indication that continued upside may be harder to come by.

Time to be choosier with AI stocks

Amid the AI investment boom, both Nvidia and other tangential stocks have seen a massive run-up in their stock prices. Yet these stocks will have to prove their AI bona fides, and they're now "show me" stories following their run-ups. Some will no doubt go on to make more gains, perhaps even big gains, but others may have a harder time.

Thanks to its favorable position in data center solutions, Vertiv belongs on investors' watchlists in case of a pullback. But it's not an immediate portfolio addition.

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Billy Duberstein has no position in any of the stocks mentioned. His clients may own shares of the companies mentioned. The Motley Fool has positions in and recommends Nvidia. The Motley Fool has a disclosure policy.

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