A new tech hardware upgrade cycle is under way, and with the pandemic propelling digital change like never before, this strong demand phase for devices and tech infrastructure has no end in sight. Companies that cater to this market indicated as much during earnings season.
Applied Materials: Chip manufacturing equipment will only grow in complexity
When it comes to all things tech, it all starts with semiconductors. And as computing needs advance and grow more complex, higher-order chips are necessary. That's where Applied Materials comes in -- it's one of the leaders in designing and providing chip manufacturing equipment.
For the various chip fab companies, AMAT is a critical partner. Its machinery prints conductive metals onto wafers, a process known as lithography, and handles other aspects of semiconductor production. It also has a division producing equipment used by ultra-high-definition OLED display makers. As hardware grows more complex, AMAT is relied upon to produce the tools that can craft it.
Business has been booming, and not just because the global chip shortage has fabs spending on new equipment to increase their manufacturing capacity. Electronics components are getting smaller, more powerful, and more energy efficient, and as such, their manufacture requires new lithography and related systems. During AMAT's fiscal Q3, which ended Aug. 1, revenue increased 41% year over year to $6.2 billion. It also increased by 35% through the first nine months of the fiscal year. This is a highly profitable operation, too. Free cash flow (FCF) was $3.8 billion through the first nine months of fiscal 2021, a FCF profit margin of nearly 23%.
Historically, AMAT has been a cyclical business, as are most companies that are closely tied to the manufacturing sector. Its sales, and therefore profits, ebb and flow as its fab clients upgrade their operations in waves. But over the long term, semiconductors will remain a basic building block of the global economy. Applied Materials will be in growth mode -- with some bumps along the way -- for a long time. But for now, it's in an all-out expansion phase. Management is forecasting another 35% year-over-year increase in revenue in the final quarter of its fiscal year. At 25 times trailing-12-month free cash flow, this stock looks like a great buy, even after a 120% rise since the start of 2020.
Arista Networks: The internet remains a highly disruptive force
Speaking of highflying stocks, Arista Networks has been on a tear as of late as well. After an up-and-down period in 2018 and 2019, during the U.S.-China trade war and a downturn in data center construction, Arista's stock is up nearly 80% since the start of 2020. Its run higher could be far from over, though.
The internet and all the services we rely on delivered through the Web are absolute staples. But it's easy to take the complex data highway that crisscrosses the planet for granted. Arista designs key hardware for that infrastructure, especially for data center and network operators. The pandemic has increased the amount of traffic traveling on the internet's highways and byways, setting off a new infrastructure upgrade cycle.
From solutions for big data centers to smaller edge computing services to businesses setting up their own data centers, Arista has tech that can help. Its software suite complements its hardware for managing and securing its customers' data flows. Business is back in growth mode, with sales up 6% quarter over quarter and 31% year over year in Q2 2021. Free cash flow was $508 million through the first half of the year, a whopping 37% of sales. The company has a stellar balance sheet, too: $3.28 billion in cash and equivalents and zero debt.
Trading at 32 times trailing 12-month free cash flow, Arista is arguably a pricey stock pick. However, the company is lapping its results from 2020, when many organizations froze spending on IT equipment and infrastructure in response to the pandemic. With revenue and profits sharply on the rise (management has forecast 21% sales growth in Q3), and data center construction climbing, the stock is a more reasonable buy right now than it would initially appear to be. The internet will continue to reshape the economy for decades, and Arista could keep playing a role in upgrading and improving its base infrastructure for a long time.
Nvidia: The new dominant name in semiconductor design
Nvidia also carries a sky-high price tag: It currently trades for 85 times trailing-12-month free cash flow, an incredible valuation for a company with a market cap of $560 billion. As incredible as it may seem, though, Nvidia is still growing at a rapid pace in spite of its size. Sales in its fiscal Q2 2022, which ended Aug. 1, were up 68% year over year to $6.5 billion, and free cash flow was up 85% to $2.5 billion.
This semiconductor designer has been on a tear for well over a year now, and its trajectory is starting to cool off a bit -- but not by much. Management forecasts fiscal Q3 sales of $6.8 billion, a 44% annual increase building on top of its 57% growth rate in Q3 last year. Its steep premium is, at least in part, deserved, given that kind of momentum.
Of course, this all depends on Nvidia's ability to keep the party rolling for a while. The evidence it will be able to do so is piling up. The company's graphics processing units are already at the heart of the video game industry, are heavily used to mine cryptocurrencies, and are being put to work accelerating computing power in data centers. It also has a fast-expanding suite of cloud-based software to help its customers improve their use of AI systems. Nvidia's R&D on semiconductors and adjacent services is at the heart of all sorts of high tech.
This company is on a course to continue carrying the torch for the semiconductor industry in the decade ahead. With such a lofty valuation, expect some volatility in the stock price at some point. But for investors with long-term horizons, Nvidia is still a buy.