Profit As The Data Center Wars Heat Up

Google’s (Nasdaq: GOOG) new cloud chief Diane Greene threw down the gauntlet recently and is pushing the company to drive its data center business harder. The world’s second largest publicly-traded company is intent to focus on its enterprise cloud services with new infrastructure and staffing.

The plans won’t be taken lightly by the two leaders in data center and cloud services, Amazon (Nasdaq: AMZN) and Microsoft (Nasdaq: MSFT). Amazon has already announced an infrastructure buildout for more data centers and Microsoft is focusing heavily on international centers for availability of its Azure platform.

#-ad_banner-#It’s too early to call a winner in the race to build out data centers and the increased competition in cloud services. All three tech behemoths have billions available to invest and drive their expansion.

There will be a more immediate winner to the buildout: an industry that has been struggling under lower growth but could be ready to surge on the increased spending. Two names emerge as leaders in the space and valuations could be about to jump.

The Cloud Wars Have Begun
When Diane Greene addressed employees in an internal sales meeting this month her message was clear: push harder.  In a break from the company’s traditional focus on technology, Greene directed employees to start selling the company’s cloud services aggressively. 

Recent hiring at Google confirms the new focus. The West Coast cloud sales team has doubled to almost 50 people over the last few months and Greene is planning on hiring a chief marketing officer. 

Greene was a founder and CEO at VMware (NYSE: VMW) for a decade before joining Google’s board and becoming the cloud chief last year, so she knows exactly what the company needs to do to be competitive in the fast-growing cloud services segment.

Research firm Gartner expects the data center industry to grow 35% over the next year to $20 billion and Google’s plans for more market share won’t go unnoticed by rivals. 

Google is 3rd in cloud services behind Amazon and Microsoft but plans on building out 12 more cloud data centers over the next 18 months from just three today. Amazon operates 12 centers with another five planned but may increase its plans on this new competitive news from Google. 

Two Winners In The Coming Data Center Infrastructure Boom
The sudden growth in data centers could be a boom for hardware suppliers. Hardware has not been the growth story for so long that the industry trades for very attractive multiples to earnings and companies spin off billions in cash to shareholders. Synergy Research Group reports that data center infrastructure spending grew 3% in the Q3 2015 to $29 billion. 

It might not take much growth to surprise the market and send shares of key suppliers higher.

The newly formed Hewlett Packard Enterprise (NYSE: HPE) holds the largest market share in the enterprise data center hardware market. The enterprise hardware group accounts for 53% of sales and 72% of operating profit, followed by enterprise services (35% of sales), software (6%) and financial services (6%). Networking revenue jumped 62% year-over-year in the first quarter with total enterprise group sales up 7% on a constant-currency basis. 

Shares of HP Enterprise have been basically flat since the November spinoff from Hewlett Packard. The split will allow the enterprise provider greater focus and cost improvements should help earnings improvement over the next few quarters. The stock trades for just 9.5 times expected 2016 earnings and the company plans on returning 7% through dividends and the share repurchase program.

Cisco Systems (Nasdaq: CSCO) holds the lead in service provider data center hardware with switches and routers accounting for 45% of sales. Total revenue only grew 2% in the most recent quarter from the year prior but the company was able to generate an 8% earnings increase through expansion of both the gross margin and operating margin. 

With a market cap of $141 billion, Cisco is more than twice the size of its next largest competitor, EMC Corporation (NYSE: EMC), in the networking hardware space. The company’s size and breadth of products gives it an advantage and amounts to high switching costs for customers.  Shares trade for 12.2 times trailing earnings and the company has returned 6.2% over the last four quarters through dividends and the buyback.

Risks To Consider: While data center growth is expected to continue, it is a cyclical business and could hit lower spending if the economy cools.

Action To Take: Position in two of the leaders for data center hardware as service providers race to build out locations.

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