Vertiv: Efficiently Absorbing AI Tailwinds (NYSE:VRT)

Investment thesis

Vertiv (NYSE:VRT) is one of the hottest stocks in the U.S. market right now, and its growth was mainly fueled by an AI and data centers mania. When I first saw that the stock rallied by 524% over the last twelve months, I thought that the stock was overhyped. However, when I delved into the company’s financial and business analysis, I understood that the massive rally was well-deserved. Moreover, my valuation analysis suggests that the stock is still substantially undervalued. All in all, I assign VRT stock a “Strong Buy” rating.

Company information

Vertiv is a company that designs, manufactures, and services critical digital infrastructure for data centers, communication networks, and commercial and industrial environments. According to the latest 10-K report, the company’s footprint spans across 40 countries on various continents.

Vertiv’s customers operate across various industries, including cloud services, financial services, healthcare, transportation, manufacturing, energy, education, government, social media, and retail. The company’s broad range of offerings includes AC and DC power management products, switchgear and busbar products, thermal management products, integrated rack systems, modular solutions, and management systems for monitoring and controlling digital infrastructure.

The company’s fiscal year ends on December 31 and there are three segments based on geographic areas covered. For the year ended December 31, 2023, 56% of Vertiv’s net sales was transacted in the Americas; 22% was transacted in Asia Pacific; and 22% was transacted in Europe, Middle East & Africa [EMEA].

Financials

Let me start by looking at long-term trends in VRT’s financial performance. Since VRT went public not so many years ago, we have financial statements available starting from FY 2016. From a long-term trend’s perspective, I can describe VRT’s financial performance as solid because the company demonstrated a 10% revenue CAGR and expanding profitability metrics between FY 2016 and 2023.

The management’s capital allocation approach is aggressive, which we can see from the extremely high leverage ratio. On the other hand, I am comfortable with a 5.7 covered ratio and VRT’s liquidity metrics are also sound.

The latest quarterly earnings were released on April 24 when VRT delivered positive revenue and adjusted EPS surprises versus consensus estimates. Revenue grew by 7.7% YoY and the adjusted EPS almost doubled, from $0.24 to $0.43.

The company enjoys strong momentum in the industry due to the increased demand for data centers powered by the artificial intelligence [AI] race between technology hyperscalers. For example, Google (GOOG) plans to pour billions of dollars into data centers in 2024. Another cloud giant, Amazon (AMZN) also plans to invest billions in data centers across the world, including Saudi Arabia and Singapore. I also cannot skip Microsoft (MSFT) when I speak about giants ramping up their data center investments. Recent news reveal that Microsoft together with OpenAI has an ambitious $100 billion long-term data center project. That said, the demand for Vertiv’s products is likely to remain robust for longer.

As a long-term investor, the most important trend I rely on is looking at how profitability metrics and cash flow change while revenue grows. As shown below, VRT has been quite successful in managing rapid revenue growth, which was fueled by the data center mania in 2023 and Q1 2024. This positive trend gives me optimism that VRT is able to continue expanding profitability in the current favorable environment for the company’s topline.

Another quite positive factor which I want to emphasize is that VRT is evenly strong across all markets where the company is present. All three VRT’s geographical segments delivered growth in Q1, both in terms of revenue and in terms of operating income.

Having improving operating efficiency as the business scales up together with strength across all geographies allowed management to boost 2024 fiscal guidance during the latest earnings call. The management now expects organic growth of 12% and adjusting operating margin expanding to 17.7%. Another factor that indirectly emphasizes the management’s confidence in the company’s profitability and cash flow is an opportunistic share repurchase program, initiated in Q1.

To sum up, Vertiv currently experiences strong demand for its products with a 60% YoY orders growth in Q1 2024 and the management expects revenue growth to accelerate in Q2. Revenue growth is managed efficiently, which we see from notable improvements in operating margin and free cash flow. The demand for data centers is expected to remain robust for longer, as all hyperscalers are betting big on AI and cloud computing.

Valuation

The stock rallied by 524% over the last twelve months thanks to the AI-fueled stock market frenzy. In 2024, the stock price doubled with a 99% YTD rally. As a result, VRT’s valuation ratios climbed extremely high and are currently substantially higher than the sector median and the last five years’ averages. That said, the stock looks way overvalued from the ratios’ perspective.

However, ratios might be insufficient to assess valuation of a growth stock. Therefore, I am simulating a discounted cash flow [DCF] model. I use an 8.6% WACC recommended by valueinvesting.io. Consensus revenue estimates are available until FY 2029. For the years beyond, I use a 9.6% CAGR suggested by. industryarc.com. I use a TTM FCF ex-SBC margin for the base year and project a 50 basis points yearly expansion. I have high conviction in VRT’s ability to improve FCF based on the solid track record of the last five years.

According to my DCF simulation, the business’s fair value is $48.75 billion. This is around 33% higher than the current market cap, meaning that VRT is still undervalued even after a big rally in the last twelve months.

Risks to consider

The only risk I see for the stock at the moment is the risk of investors taking profits after such a massive rally in the last twelve months. The stock is at an all-time high, which can become a trigger for a temporary stock pullback.

The company generated almost half of its FY2023 revenue in Asia Pacific and EMEA regions. This means that the company faces all substantial risks which are attributed to operating internationally, including foreign exchange risks and potential disruptions due to changes in international trade regulations. Unfavorable shifts in foreign exchange rates or international trade rules might lead to unexpected expenses for VRT.

The company does not disaggregate its revenue by countries. However, since Asia Pacific represented 22% of total revenue in FY2023, I can assume that revenue generated in China represents a notable portion of the total. Since relationships between the U.S. and China are currently in a state of a “Cold War”, there are risks that the company might face some regulatory headwinds from both sides.

Bottom line

To conclude, VRT is a “Strong Buy”. The company operates in a hot industry which is expected to deliver solid growth over the long term because Data Centers across the world are ramping up. VRT demonstrates efficiency in absorbing favorable industry trends as its profitability profile is improving. Despite the stock price doubling YTD, there is still a 33% upside potential, according to my DCF model.