1 Overlooked Stock for a New AI and Cloud Computing Era

The advent of generative artificial intelligence (AI) in the cloud is changing what the world's data centers look like. Faster computing power is suddenly en vogue, and a new breed of chips (GPUs) are gobbling up market share. Along with faster computing, though, comes the need for more data. 

This could land Pure Storage (PSTG 1.40%) on your radar as a potential top beneficiary of advancing computer needs. The company makes digital data storage products. This is a tough market right now, as many data center operators have paused their spending in 2023 to work down existing inventory and revamp their data center designs for generative AI. Nevertheless, Pure Storage is outperforming many of its peers and could be a growth stock for many years to come. 

Memory has a lapse in sales, but not Pure Storage

An excess of memory chips and related components started to crop up in late 2022, and that effect is now being exacerbated by data center companies shifting their spend to equipment like Nvidia systems for accelerated computing. As a result, most of the big players in the enterprise-grade data storage market, like Dell and Hewlett-Packard Enterprise, have been reporting declining sales of their storage products.

Pure Storage hasn't been exempt. The company's product revenue fell 3.6% year over year to $400 million in second-quarter fiscal 2024 (the three-month period ended in early August 2023). However, Pure Storage pioneered a unified data storage platform that also features subscription services, giving customers the option to offload some of the heavy lifting of data management infrastructure. The company's subscription revenue continued to grow steadily despite the current memory market downturn, notching a 24% year-over-year growth rate last quarter to $289 million.  

The result is a business that is outperforming its peers during tough economic times. Total revenue was up 6.5% in Q2, and by most metrics, Pure Storage remains profitable -- though GAAP net income just recently dipped slightly into the red. This is in spite of ramping up new growth initiatives like its FlashBlade//E device for storing massive amounts of unstructured data. The higher performance FlashBlade//S also continues to win over lots of new customers, including landing a big new deal last quarter for a customer working on a generative AI project.

Are memory subscriptions the future?

At this juncture, a rebound in product sales will be key to Pure Storage returning to more robust growth. However, the long-term trend has been toward its flexible data subscription services, a trend that has continued even amid the current downturn. 

Data source: Pure Storage.

There has been some bumpiness in profitability for this disruptor of the traditional enterprise storage market, but Pure Storage is overall still making progress on the bottom line. Adjusted operating profit margins (16.2% in Q2, down from 16.4% last year) are expected to rebound to nearly 18% next quarter, and in the meantime, free cash flow remains healthy. 

Data by YCharts.

When Pure Storage lands a subscription deal, it recognizes revenue (and thus profit) from it over time. Thus, overall revenue is expected to accelerate back to a double-digit clip next year, and should boost profit margins when that happens. Shares currently trade for 24 times Wall Street analysts' expectations for next year's earnings per share, and about 18 times next year's expected free cash flow.

For a company with a long runway of growth ahead of it, many years as high-performance cloud computing and AI keep expanding, this looks like a reasonable price tag to me. Pure Storage is a great dollar-cost average stock in my book.