I have viewed the current narrative (and general hysteria) surrounding ChapGPT and the “AI arms race” with a certain amount of humor and absurdity. Apparently, and according to the popular press, the AI battle is solely between Microsoft (MSFT) and Google (GOOG) (GOOGL). While I certainly agree that Microsoft has delivered a shot across the bow of Google – a company that was arguably caught flat-footed despite years of high-level investments in AI – the truth is that most large corporations have been making significant investments in AI for many years. That being the case, the AI theme will be pervasive across almost all industries and is certainly much bigger than just MSFT and GOOG. There will be many winners – and many losers.
Today, I want to discuss the “sure-fire” winners that are going to prosper no matter what company grabs the highly visible headlines. These are the companies that will be supplying the “picks and shovels” to make AI a reality for almost all of the companies participating in the theme. My picks are Datadog (NASDAQ:DDOG), Broadcom (AVGO), and Nvidia (NVDA). In addition, and following the “picks and shovels” theme, investors should take note that the semiconductor sector in general – as represented by the VanEck Semiconductor ETF (SMH) – has dramatically outperformed the broad market averages, as represented by the Vanguard S&P 500 ETF (VOO) and the Nasdaq-100 (QQQ), on a YTD basis:
No doubt part of that out-performance is due to the realization that without high-speed networking chips and high-performance compute power, AI’s potential simply will not be realized.
AI Investment Theme: “Picks and Shovels”
As the heading suggests, my opinion is that the “sure-fire” winners in AI will be the companies at the nuts-n-bolts level. This theme is similar to the California gold rush, when the sellers of picks-n-shovels made much more money than the average gold prospector. Investors should consider the same strategy when it comes to investing in AI.
On a base level – and for simplicity’s sake – I view AI as broken down into three main categories:
- Supplying/Moving the Data
- Processing power to run the AI/ML algorithms on that data
Data is arguably the most important piece of the pie. Without good mega-data sets, it doesn’t matter how good the AI/ML algorithm is, or how fast those algos are processed, the results will be non-optimal and potentially totally worthless. As the old expression goes: “garbage in, garbage out.” This is certainly the case in AI.
From that standpoint, companies will be looking for experts in data aggregation, cloud monitoring, and business analytics. In this field, I like a company like Datadog. The stock of DDOG, like the semiconductor sector, has really taken off this year (+22% YTD). However, DDOG was a high-flyer prior to the 2022 technology bear market and – as the chart below clearly shows – despite the YTD rally the stock is still more than $100 below its peak of ~$193 back in November 2021:
In my opinion, DDOG is a great opportunity for investors looking for a “growth” investment in AI. DDOG is due to release its Q4 earnings and FY23 guidance tomorrow (Thursday) before the market opens. Here’s what to expect.
As the graphic below clearly shows, DDOG has a very strong track record of rapidly growing revenue and (non-GAAP) earnings that have consistently and significantly beat consensus estimates:
If DDOG hits the consensus FY22 revenue estimate of $1.65 billion, that would equate to a 60% yoy increase. Q4 non-GAAP estimates for $0.19/share would be up 72% from Q4 of FY21 ($0.11/share).
The reason I like DDOG so much is displayed in this slide from a November presentation (which I encourage you to view in its entirety):
That is because the company began by developing a real-time Unified Data Platform that enables companies to easily aggregate and monitor their data across various “data silos” and formats. This is the purple line above and is the heart of DDOG’s platform. Over time, and as shown in the chart, DDOG has added feature-rich innovations like infrastructure and performance monitoring and cloud security. For companies wanting to “go long AI,” DDOG offers them, compelling and consolidated platform solution. I say that because DDOG is highly levered to grow with cloud spending. And to be heavily invested in AI, companies have to be heavily invested in the cloud, because that’s where the mega-data is going to come from.
The graphic below is a snapshot of the company as of the end of Q3 (ended in Sept. 30, 2022):
Note that DDOG’s platform is operated as a SaaS-based business on which DDOG has 22,200 customers of which 2,600 contribute an ARR (annual recurring revenue) base of $100,000+. Also of note is that YTD in FY22 (i.e., through the first three quarters), DDOG achieved a 20% operating margin, a 24% free cash flow margin, and delivered $364 million of FCF. I expect Q4 to be a continuation of this excellent and growing performance track record.
Now, the risk with a high-growth company like DDOG is that revenue growth significantly slows down or misses expectations. In that case, the stock could get hammered. I say that because DDOG trades with a forward P/E of 94x – so there is not much room for disappointment. So, if that’s not the kind of risk/reward you are looking for, you should consider my next pick instead.
Supplying/Moving The Data
Clearly, efficient and fast movement of mega-data to-and-from the cloud is going to be key for success in AI. From that standpoint, another sure-fire winner is going to be Broadcom – which arguably operates the best high-speed networking development platform (both hardware and software) on the planet.
That being the case, Broadcom always seems to be at least one step ahead of the competition in high-speed networking. As a result, and as we know in the technology space, that’s where the margin is (i.e., the leading edge of technology). And this leading position in high-speed networking is the “secret sauce” that enables Broadcom to consistently deliver such strong free cash flow. It also is why Broadcom is going to be a big winner in the AI arms race.
As I have pointed out in my past Seeking Alpha articles on Broadcom, the company has sold out its entire capacity at the beginning of FY23 – something the company also did in FY21 and FY22. And, unlike most companies in the technology sector, AVGO’s strong FCF profile has enabled it to become one of the best dividend growth stocks in the entire S&P 500. AVGO currently pays an $18.40/share annual dividend, that’s good enough for a 3.05% yield.
Broadcom’s Q1FY23 earnings are due out on March 2. In Q4 of FY22, announced in December, AVGO raised the quarterly dividend by 12% to $4.60/share. The point is – Broadcom continued to perform at a very high level despite the challenges of the 2022 bear market. Indeed, for full-year FY22, Broadcom generated a whopping $16.3 billion in free cash flow (49% of revenue). With a forward P/E of only 14.8x, and a very strong backlog, AVGO is a steal here.
Processing Power To Run AI/ML Algorithms
Now that we have figured out how to aggregate and move the mega-data sets, now we need some really fast application-specific hardware to run the AI/ML algorithms on. For these solutions, I turn to the leader in high-performance processing solutions: Nvidia (NVDA).
After getting severely mauled by the 2022 tech bear market, I was not surprised at all when Nvidia came charging out of the gates this year – especially given all the hysteria over ChatGPT and AI. Indeed, on a YTD basis, NVDA has even left the broad semiconductor sector in its dust:
That’s because industry insiders and investors realize that NVDA has been, and will continue to, designing some of the best high-performance computing (“HPC”) solutions for the AI space. In addition to leading-edge processing hardware, NVDA also has been a leader in AI software and Data Science Solutions. Indeed, Nvidia NGC is a repository of containerized applications you can use in deep learning, machine learning, and HPC projects.
The bottom line: Nvidia has excellent AI positions in both processing and compute hardware as well as software – with one of the most complete suites of software tools in the entire industry.
That said, and somewhat like DDOG, NVDA is a highly-valued company (forward P/E of 70.3x) and a growth opportunity that may not fit every investor’s risk/reward comfort level.
Summary and Conclusion
So those are my three “sure-fire” picks for investors interested in the long-term potential of AI. To summarize – here are the three basic “picks-n-shovels” categories:
- For “Data,” it’s Datadog
- For “Data Movement,” it’s Broadcom
- For “Processing Power” (and AI software), it’s Nvidia
Of the three, Broadcom is the best bet for those investors that have a lower risk/reward comfort level, while Datadog and Nvidia are higher-growth opportunities with a correspondingly higher risk/reward profiles.
I’ll end with a three-year total return comparisons of these three companies along with the S&P500 and triple Qs and observe that despite the mauling during the 2022 bear market, all three of my picks have significantly outperformed the S&P 500 and the Nasdaq-100 over the past three years:
I suspect that will continue to be the case over the next three years as well.