Amphenol Corporation (NYSE:APH) is a leading global provider of connectors and interconnect systems. Amphenol's traditional end markets include automotive, communications, and consumer electronics. However, with the advance of AI technology, Amphenol expanded rapidly into the data center market and will become one of the key suppliers of Nvidia's next-generation Blackwell server systems. I believe Amphenol is well positioned for sustainable growth and margin expansion during the next 2-3 years. However, the stock is trading at a significant valuation premium, which has priced in the growth potential.

Business description and operational analysis

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Amphenol was founded in 1932 in Chicago. The company's initial order was from RCA, which requested a type of connector made out of new materials. Since then, RCA has been focusing on connecting technologies. The company grew both organically and through acquisitions. During the past two decades, Amphenol has made some significant acquisitions, including "the purchase of Teradyne Connection Systems in 2005, the acquisition of GE's Advanced Sensors Group in 2013, the 2016 acquisition of FCI, and the 2021 purchase of MTS's sensor business". During 2024, the company made two acquisitions: Carlisle Interconnect Technologies and Luetze

Amphenol operates three reportable business segments: Harsh Environment Solutions, Communication Solutions, and Interconnect and Sensor Systems. The Communication Solutions segment is the largest, contributing approximately 40% to the consolidated revenue. The remaining revenue is roughly evenly divided between the Harsh Environment Solutions segment and the Interconnect and Sensor Systems segment.

Before 2024, investors rarely associated Amphenol with the AI boom as the company's products are mostly used in traditional end markets such as automotive, communications, and consumer electronics. This all changed when Nvidia announced the configurations of the next-generation GB200 NVL72 system, which "densely packs and interconnects the GPUs using a copper cable cartridge for operational simplicity." Amphenol is later confirmed as the supplier for Nvidia's copper cable cartridge, which includes a significant amount of value of copper cables and interconnects.

In April 2024, an Evercore ISI analyst wrote a report and estimated that "the value of APH materials in each system estimated to be between $100,000 and $120,000. Preliminary estimates indicate that this new system could potentially generate approximately $700 million in revenue. In the long term, revenue from this initiative is expected to surpass $1.0 billion."

Amphenol's AI-related revenue did take off. For the most recent quarter, sales in the IT datacom business grew by 76% organically, almost entirely driven by AI-related demand. For the full year, revenue from the IT datacom business grew by 57%. The IT datacom market has become meaningful for Amphenol, contributing 27% of the consolidated sales for the fourth quarter and 24% for the full year. The growth momentum will continue as the company booked over $5 billion in orders in the fourth quarter, which represents a growth rate of 58% on a year-over-year basis. Amphenol's management explained during the Q4 earnings call that the strong order growth is "driven primarily by data center demand related, in particular, to artificial intelligence or AI investments by a number of our large customers."

Management is very optimistic about the continued growth in the company's AI-related revenue with the increasing adoption of AI technologies across various industries. However, management alluded that Amphenol's current market share in the high-end AI server market is not sustainable.

Financial and valuation analysis

For the most recent quarter, Amphenol reported sales of $4.3 billion, up 30% on a reported basis and 20% organically year-over-year. For FY2024, Amphenol reported sales of $15.2 billion, up 21% on a reported basis and 13% organically year-over-year. Adjusted operating margin reached 22.4% in Q4 2024, a record high for the company.

Over the past 5 years, the company's revenue has grown at an annual rate of 12.8%. The company's gross margin has been remarkably stable at 31.0-33.8%. Its operating margin is also relatively stable, oscillating between 19% and 22% during the same period. Both gross margin and operating margin increased in FY2024 as the gross margin of the fastest-growing AI business is higher than that of the traditional end market. I expect the company's gross margin and operating margin to continue the current upward trend and improve over the next 2-3 years.

In terms of DCF valuation, if we use a 10% discount rate and optimistically assume that Amphenol can grow its adjusted EPS at 16% over the next 10 years and 4% afterward, the implied current intrinsic value per share is $49.5. At the current price of $70, Amphenol's stock price has no margin of safety at all. Using the reverse DCF tool, Amphenol would need to grow its adjusted EPS at almost 21% annually during the next decade to justify today's valuation. I wouldn't rule out such a possibility as Amphenol's AI revenue is likely to grow rapidly for 2-3 years. However, Amphenol's traditional markets are cyclical in nature. It seems inappropriate to factor in very optimistic growth projections for those end markets.

Risk analysis

Regarding risks, I am mostly concerned with three risks for Amphenol. The first is the less-than-expected demand for Nvidia GB200 NVL72 server systems. This risk is partially playing out as China's DeepSeek made a breakthrough technological leap, which raises the question of whether the massive AI capital expenditure is justifiable.

Secondly, there is a potential risk from tariffs as Amphenol sources many components from China. This risk is also at play as China and the U.S. both threatened to levy additional tariffs on each other.

Thirdly, Amphenol's traditional end markets are very vulnerable to cyclical macroeconomic conditions, especially the industrial end market, which has already been experiencing challenges. Further weakness in customer demand will hurt Amphenol's revenue growth.

Conclusion

In conclusion, while Amphenol is facing some weakness in some of its traditional end markets, the company is well-positioned for growth during the next 2-3 years, with potential margin improvement driven by AI-related demand. However, at the current price, the stock trades at a significant valuation premium to its DCF value. I believe the stock offers no margin of safety at the current market cap and suggest investors stand on the sideline.

This article first appeared on GuruFocus.