Vertiv Stock: Further Upside Possible, Driven By Generative AI (NYSE:VRT)

When you have a stock that has already rallied by over 250% this year alone as is the case with Vertiv Holdings (NYSE:VRT) and is trading at a forward price-to-sales of nearly 90% above the median for the industrial sector, you better have some strong justification for any future upside. This is precisely the aim of this thesis, and for this purpose, I consider additional sales opportunities related to the increasing proliferation of AI workloads in data centers.

However, fully conscious that artificial intelligence is currently a field subject to a lot of hype, especially after OpenAI’s ChatGPT has helped to popularize the Generative AI theme, I make sure to exercise moderation regarding the potential benefits to also account for risks.

For investors, it is important to start by deciphering the relationship between ChatGPT and Vertiv, which is one of the stakeholders in DCPI or data center physical infrastructure as a provider of power and cooling solutions.

Nvidia’s AI Chips need More Power and Cooling

First, as some may know, giant semiconductor supplier Nvidia (NASDAQ:NVDA) has been selling record numbers of Graphics Processor Units or GPUs this year. The reason is the appeal of its H100 AI-enabling chip which is the very driving force behind ChatGPT, to both enterprises and cloud service providers as they build intelligent infrastructures.

Looking at the next step, once purchased, the chips have to be fitted into racks or server cabinets as pictured below as they get deployed in data centers. To this end, Nvidia also sells HGX platforms which already include intelligent chips. Furthermore, compared to normal IT servers containing CPUs or Compute Processor Units, which can fit into 10 kilowatts racks, AI workloads including GPUs are much more power-hungry and need 50kW to 100 kW racks. This means an increase by a factor of 5 to 10 both in terms of high-capacity PDUs or power distribution units, while not forgetting cooling equipment, namely to promptly extract away the heat generated before critical server units undergo thermally deterioration.

Looking further, there are also direct-to-chip technologies involving liquid cooling as the power per chip goes beyond the 1000 W mark which means that the environmental demands for hosting GPU workloads are much more stringent than conventional CPUs thereby representing opportunities for a DCPI supplier like Vertiv which is well positioned.

Well-Positioned in the DCPI Market

This market consists of three main players, including Schneider Electric (OTCPK:SBGSY), and Eaton Corp (ETN) which are much larger than Vertiv as shown by the market capitalizations in the table below.

Looking at historical figures, this market grew by around 10% in the fourth quarter of 2022, driven mainly by increases in pricing as suppliers passed on higher costs for raw materials, components, and logistics due to high inflation and supply chain constraints to customers. This growth was broad-based, encompassing power distribution and rack thermal management systems with North America and Asia-Pacific recording double-digit growth while EMEA (Europe, Middle East, and Africa), and China recorded single-digit growth rates on a YoY basis.

Subsequently, growth accelerated to 15% in the second half of 2023 despite the normalization of supply chain conditions, driven mainly by existing backlog levels, and high data center utilization in tandem with increasing rack power densities required to support the hosting of generative AI-related applications. Geographically, North America, Asia Pacific, and EMEA grew at double digits while China was relatively flat YoY.

Looking at individual performances, recording 22% YoY revenue growth, Vertiv has not only been gaining market share much faster than its peers as shown below, but it has also managed to beat the DCPI market’s 15% performance.

This is explained by the portfolio consisting of “critical infrastructure technologies, across the entire span of the powertrain, the thermal chain and IT-wide space infrastructure, something that very few companies truly have”. As such, these products can cater to a wide range of power densities irrespective of CPUs or GPUs. In other words, they have been designed to be rapidly adapted across different environments, or those operated by hyperscalers (big cloud providers), colocation providers, and enterprises. Vertiv is also well-positioned to specifically address liquid cooling in the context of direct-to-chip technologies which represents a more precise type of heat extraction than those functioning with racks or data centers and may be needed for new Generative AI workloads.

Therefore, Vertiv is a beneficiary of DCPI evolving from the Covid-led digital transformation demand to Generative AI purpose-built facilities in a market expected to grow at over 13% this year. In 2024, there should be some moderation, but, still, AI deployments should keep growth rates higher than historical levels, according to Dell’Oro Group.

Valuing Vertiv using Moderation because of Risks

To value Vertiv, I consider that Nvidia is expected to see its revenues surge by 117.9% and 54.25% for the fiscal periods ending in January 2024 and January 2025 respectively. The bulk of its revenues or more than 80% are made of GPU chips.

Now, these chips have to be bought first before being deployed in data centers which means that there is a lag before these become favorable to Vertiv’s income statement in terms of DCPI equipment sales and whose fiscal year ends in December or just one month before Nvidia’s as shown below. Thus, we can reasonably expect that most of the above 117.9% revenue growth expected for Nvidia’s FY-2024 should impact Vertiv’s 2024 fiscal year (as tabled below), which will end in December next year. For this matter, the company’s CEO, in his prepared remarks during the third quarter 2023 (Q3) earnings call on October 25 also supports this idea of obtaining more AI-related business in 2024 as follows: “So overall, AI is coming, and we anticipate it will show up. We’re in a more pronounced manner in 2024″.

Now, based on Vertiv’s ability to grow its market share faster than its competitors as per the above comparison table, it can be reasonably expected to harvest 22% of Nvidia’s 118% growth. However, in the name of moderation, I divide this figure by half resulting in a revenue growth expectation of 11% (22/2), which would still be higher than the 9.24% expected by analysts.

There are three reasons for this moderation. Firstly, other companies are competing for a slice of the DCPI including China’s Huawei, Legrand SA (OTCPK:LGRVF), and Mitsubishi Electric (OTCPK:MIELY). Furthermore, Schneider Electric whose sales have been impacted to a higher degree by supply chain constraints is now seeing things normalize, while its technology is catching up rapidly with Vertiv in the fast-growing thermal management solutions. Second, traditional IT spending or those not related to AI could witness a slowdown as U.S. GDP growth in 2024 should be much lower than this year. Third, Vertiv may face a competitive threat from GPU manufacturers themselves trying to directly embed other forms of cooling at the chip level itself which could result in Vertiv being circumvented.

As for valuations, since the forward price-to-sales of 2.48x for FY-2024 (as per the above table) is built on expected sales of $7.51 billion, or a YoY growth of 9.24%, an 11% YoY growth would reduce the P/S to 2.08x ((2.48 / 11) x 9.24). Conversely this results in a target of $58.07 ((11 / 9.24) x 48.78) based on the current share price of $48.78.

Vertiv, with its Higher Momentum Grade, is a Buy

Still, this target could be exceeded if the company beats revenue and earnings estimates for the fourth quarter of 2023 (Q4) when the financial results are announced around February 22. The reason is that the topline of $1.88 billion being estimated by analysts would constitute a 13.32% growth while the management’s comments during Q3’s earnings point to the possibility of Q4’s growth being like Q3’s, or 17.66%. They also talk about “velocity is increasing” with the order book about AI-proof data centers being more than tens of millions of dollars.

Another supporting factor for this bullish position is the stock’s momentum grade of A+ which has seen it achieve new highs. Therefore, even if it is richly valued, I am bullish on Vertiv, especially considering that the target of $58 is a fair price as it factors in uncertainty both regarding the competitive landscape and uncertainty concerning demand for conventional IT due to lower economic growth in 2024.

Moreover, for risk-averse investors, its debt-to-equity ratio of 181% is well above peers, but the benefits of improved profitability and capital allocation have resulted in sustained improvement both in cash flow from operations and FCF as charted below, or the charts showing net uptrends since the June 2022 quarter.

In conclusion, this thesis has shown how additional sales opportunities related to Nvidia’s GPUs translate into a better stock value for Vertiv as AI workloads make their way into more data centers not only in the U.S but also in Europe, and the Asia Pacific (excluding China) according to the above-mentioned geographical data.

Finally, I have been conservative in my bullish estimate, but the ChatGPT phenomenon continues to unfold due to its ease of use compared to other flavors of AI. Thus, Vertiv should see sustained demand for its DCPI products as AI workloads consume 5 to 10 times more power than for conventional IT, without forgetting the cooling aspect.