Data-center gold rush boosts Eaton and Terex

  • By Jack Hough,
  • Barron's
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In the cloud, everyone’s a hoarder. Some stash away photos on Apple’s iCloud or videos in their Facebook posts. Most litter the internet with behavioral clues for the likes of Alphabet and Amazon.com to sort through. And many pay companies like Netflix to hoard on their behalf.

Behind this binary buildup is an astonishing pace of spending. This year alone, four U.S. dot-com behemoths—Amazon (AMZN), Microsoft (MSFT), Alphabet (GOOGL), and Facebook (FB) —will put a combined $40 billion toward new data centers. That’s close to the market value of the retailer Target (TGT). Spending is up 36% from last year, and growth has been accelerating.

Key suppliers of gear for these data centers are loving it. In July 2016, Barron’s recommended shares of Arista Networks, which has been grabbing market share in network switches from Cisco. They have returned 275% since that article. But the data-center gold rush isn’t just profiting Silicon Valley. It’s a rising source of income for the hard-hat set, too, as JPMorgan analyst Ann Duignan points out in a recent report. She calls out two examples: Eaton (ETN), which makes electrical systems for power-hungry buildings, and Terex (TEX), whose articulating boom lifts—some call them cherry pickers—are just the thing for putting up low, wide buildings.

There are others. Ingersoll-Rand (IR) makes Trane climate systems, which can help keep all of those hard-thinking servers cool. CyrusOne (CONE) isn’t an industrial company, but rather a landlord and builder focused on companies that want space for new data centers, including some of the aforementioned hyperscale players. “We’re taking a manufacturing approach to construction, focused on supply-chain efficiency,” its chief executive, Gary Wojtaszek, told us this past week.

Apart from CyrusOne, these aren’t pure-play cloud investments. For example, although Eaton gets roughly 60% of its revenue from electrical products, systems, and services, only about 20% of that comes from data centers. And Terex, beyond making cherry pickers, makes construction cranes, the rock crushers used at quarries, and other massive machines.

Think of these as companies benefiting from a cloud tailwind and whose shares are cheaper than the technology sector’s fast growers. Bright as the future still appears for Arista, it carries a premium valuation of more than 30 times projected earnings for the next four quarters. Eaton can be had for 15 times earnings, and Terex, 11 times.

A typical data center costs $450 million to build, not including the servers and such. CyrusOne’s development yields—yearly rent minus expenses, as a percentage of the construction investment—are about 15%, providing a healthy incentive to build. Data centers need meticulously regulated power with no outages, so electrical systems, including generators; so-called uninterruptible power supplies; and battery arrays can take up 40% of the construction budget. That’s about twice as much as the building’s shell and raised floor.

Commercial real estate can be prone to overbuilding, but there is reason to believe that new data storage will remain in fierce demand for years to come. At the beginning of this month, Verizon Communications became the first U.S. carrier to offer 5G service. It’s only for fixed broadband connections for homes in four markets, but over the next two years, customers will see similar services across the U.S., and 5G mobile service, too. Eventually, astounding data speeds with near-zero lag could unlock new uses for the internet and extend the storage boom.

“When I hear 5G, I hear cha-ching,” says Wojtaszek. “Twenty to 30 times today’s bandwidth means for every minute of the day there’s that much more data. Some of it might be stupid stuff, but no one ever gets rid of it.” That’s especially true, he says, now that artificial intelligence can turn old data into new insights.

Eaton stock has gained 70% over the past three years, but it still looks reasonably priced. Last month, UBS analyst Steven Winoker upgraded it to Buy from Neutral with a $100 price target, implying 14% upside from recent levels, plus the 3% dividend. Organic growth has surged last year and this year, following a three-year slump, and on the company’s latest quarterly earnings call, management made clear that data centers are a key reason. “We’re seeing strong global demand for new facilities in hyperscale and internet 2.0 applications, and importantly, we’re winning in this space,” said CEO Craig Arnold.

Beyond data centers, Eaton is benefiting from growing military spending and healthy demand for trucks in North America, and a rising oil price bodes well for Eaton’s products for drillers, pipelines, and refiners. Earnings per share are seen rising 15% this year and 10% next year, with free cash flow exceeding earnings over the next three years.

Terex makes cherry pickers under the Genie brand, which has been gaining market share. The broader product category features what are called aerial work platforms, or AWP, and includes not just articulating but also telescopic booms, scissor lifts, mobile platforms for warehouses called runabouts, and more. All are designed to safely lift a worker or small group of workers.

Building a data center can require about 600 work platforms. Most sales of them are made to rental companies. That helps protect Terex from would-be market entrants from overseas, because rental companies prefer established players with high residual values and dependable supplies of parts.

The worldwide fleet of aerial work platforms has been expanding in recent years, and a typical machine lasts eight years before needing replacement. This year, the business is expected to bring in half of Terex’s revenue, up from 30% five years ago. In a recent presentation on the segment, management pointed out that growth has accelerated this year, and margins are rising with the increase in revenue.

Despite Terex’s solid growth this year, its shares have slid from $48 to about $39 on concerns that rosy conditions could mean a peak is near. But maybe not. “Data-center expansion should provide significant support for an extended cycle in AWP demand,” wrote JPMorgan’s Duignan this past week. Her price target of $59 represents 15 times her earnings forecast for next year, and implies 50% upside for shares.

Barron’s cut a winner too soon with Ingersoll-Rand last year, after the stock had gained 36% in less than a year. Since then, it has returned 34%, which is four points better than the S&P 500 index (.SPX). Is it too late to get in? One analyst who doesn’t think so is Stephen Tusa; readers might recall his prescient argument a year ago in these pages that General Electric (GE) was no bargain.

Tusa upgraded IR shares to Overweight from Neutral last month, noting that the company has a healthier business mix than in past years, with particular strength in commercial air conditioning, including service and controls. The company makes specialty systems for cooling data centers, which can restart in seconds in the event of power outages, and offers services for minimizing power usage, and while it doesn’t break out the sales contribution from these, it calls data centers an “important vertical.” Shares go for 17 times forward earnings estimates. Tusa’s $118 target suggests 15% upside, plus the 2% dividend.

CyrusOne is structured as a real estate investment trust, meaning it passes the bulk of its earnings through to shareholders as distributions. The shares recently yielded 2.9%, perhaps not a big draw with the 10-year Treasury yield recently holding above 3%, but consider two things.

First, distributions have been growing rapidly in recent years, propelling hefty share price gains. CyrusOne has returned 300% cumulatively over the past five years, versus 195% for larger rival Equinix (EQIX). Second, a modest yield combined with brisk payment growth—distributions are expected to continue climb at a double-digit yearly pace over the next several years—could be a better mix than a high yield and slow growth if bond yields continue to rise.

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