2 Behind-The-Scenes Winners Of An Unstoppable Trend (CA, NEWR)

One of the hottest trends over the last few years has been the shift in electronics and tech to what is called the Internet of Things (IoT).

The IoT is a convergence of electronics and internet connectivity, in which virtually every electronic device and household appliance can be controlled through a single internet connection. It’s the next evolution of connectivity and has the potential to rival the importance of smartphones, tablets, and even home computers.

Research firm IDC estimates the market for IoT products could triple to $1.7 trillion in 2020 from just $655 billion in 2014. Another firm, Smart America Challenge, estimates that cities around the world will invest as much as $41 trillion over the next 20 years to integrate IoT infrastructure into city planning.

Most IoT investing has targeted the connected products themselves like wearables, connected-home devices and hardware — but success depends on finding the needle within a haystack of companies that could produce the next hot consumer gadget.

There’s one common theme that connects all IoT products — a theme that could mean a boom in earnings for one industry. Investing in the best-of-breed within this industry could allow you to benefit from the IoT trend without having to find the next consumer electronics breakthrough.

The One Thing All IoT Products Need

The common theme that ties all IoT products is the need for massive data analytics and processing. Data from these devices is collected, analyzed, and stored to provide a better user experience. The embedded software and sensors within electronics such as connected home thermostats and security systems will be constantly collecting data.

The IoT isn’t just for consumer electronics either. The trend could be a big part of how local governments operate in the very near future. For example, the city of Boston recently installed a sensor-based gunfire detection system that can alert police within seconds. In other cities, flying drones are being used for everything from analyzing traffic patterns to fighting fires.

Beyond granting the ability to allow users to control their physical world through technology, the inconceivable amount of data created is a gold mine for businesses seeking to understand their customers.

The real winners in all of this are the companies that provide those data processing, analytics, and storage needs…

CA, Inc. (CA) is a software-as-a-service (SaaS) provider to enterprise customers. They are a market leader in application performance monitoring, IT process automation, and network management. CA touches multiple points in the IoT trend, from enterprise solutions for management and data security to services enabling mobile application implementation.

Management estimates its addressable market will grow to $39 billion by 2019 from $29 billion in 2014. The company generated more than $850 million in free cash flow last year and returned more than $1.1 billion to investors through the dividend and share repurchases over that period. Shares trade for just 12.1 times trailing earnings, a multiple better suited to companies with much slower growth and a discount of 40% to the general market.

Earnings are expected to be flat over the next year but the company has beaten estimates in 15 of the last 16 quarters. I am estimating earnings of $2.70 per share on strong growth in SaaS and the company’s aggressive share buyback program, driving a target price of $40.50 on a 15-times earnings multiple.

New Relic Inc (NEWR), on the other hand, is a pure play on the theme of data analytics and performance. The company provides software analytics and applications data monitoring for companies of all sizes. New Relic stores and processes more than two million analytical events for its customers every minute.

Sales for the current fiscal year ending in May are expected at $255 million, which represents an annualized growth of 59% over the last three years. The company reached positive cash flow from operations last year and has $196 million in balance sheet cash with no long-term debt.

While the company is still expected to post a loss, it could turn to profitability by next year based on a reduction of expenses by 22% of sales over the last three years. My target of $40.83 per share is based on expectations for $325 million in sales for fiscal year 2017, but shares could go much higher on investor sentiment as the company becomes profitable.

The IoT boom will bring winners and losers in consumer electronics, but the need for processing and analytics of massive amounts of data will be a boon for leaders in applications management and enterprise services. 

Risks To Consider: The IoT trend is increasing rapidly but still a longer-term theme. Stocks may be vulnerable to overall market sentiment.

Action To Take: Take advantage of the common need across all IoT devices with long positions in data processing, analytics, and enterprise solutions like CA (price target $40.50) and New Relic (price target $40.83).

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