3 Top Stocks to Play the Data Center Upgrade Cycle in 2022

Facebook’s recent corporate rebrand to Meta Platforms has set off a firestorm of media headlines surrounding terms like “metaverse,” “web 3.0,” and “cryptocurrencies.” But even before that, lots of organizations had already started upgrading their data centers to get ready for more advanced web-based services and experiences.

A new wave of tech hardware construction is thus underway, and Advanced Micro Devices (NASDAQ:AMD), Arista Networks (NYSE:ANET), and Fortinet (NASDAQ:FTNT) look like top buys right now. Here’s why these are three top stocks to play the data center upgrade push.

Image source: Getty Images.

1. AMD: Gobbling up market share of the web’s basic computing unit

It doesn’t look like AMD’s pending acquisition of fellow chip designer Xilinx (NASDAQ:XLNX) will get done in 2021, as it’s still pending sign-off from regulators in China. Management said it hopes to finalize the $35 billion acquisition in early 2022. Xilinx, which is the leader in field-programmable gate arrays (FPGAs), will open up a new front for AMD as it gobbles up market share from Intel (NASDAQ:INTC) in multiple areas. 

Even should the Xilinx deal get hung up by China (regulators in the U.S., U.K., and Europe have already given the go-ahead), AMD will be just fine. AMD’s CPUs for data centers (one of Intel’s most important business lines) have been building steam for years. And along with Nvidia, AMD GPUs designed for artificial intelligence are also a key growth driver for the company.

But FPGAs from Xilinx, a flexible chip type that can be reprogrammed at the hardware level, have also been on the offensive. Intel acquired a couple of FPGA firms in recent years, but that segment has mostly stalled out while Xilinx has been growing at a healthy clip. Together, AMD and Xilinx would be a powerful force and help AMD continue to eat away at Intel’s massive lead in the semiconductor industry.

Besides sustaining AMD’s stand-alone growth momentum, Xilinx will improve AMD’s profit margins, and boost research and development spending. Currently, AMD stock trades for 61 times trailing-12-month free cash flow and 44 times next year’s expected earnings. This valuation implies another year of rapid growth for the company in 2022, which looks more than viable given the high demand chips are in and the rapid pace of data center upgrades (for example, Meta choosing AMD chips to help power the metaverse). Adding in Xilinx could just be extra gravy. I remain optimistic on AMD’s prospects for the long term.

2. Arista Networks: Constructing the backbone of cloud computing

After a few years of struggle, Arista Networks stock was back on the rise in 2021 and set fresh all-time highs throughout the year. The company made a solid rebound from the adverse effects of the U.S.-China trade war that were exacerbated by the early days of the pandemic, and Arista’s sales are in strong growth mode once again.  

Arista designs open-source switches and other networking equipment. As it’s a key ingredient in data centers and other internet infrastructure, a surge in web traffic and cloud computing has Arista’s hardware in high demand right now. With order lead times extending well into 2022, management expressed confidence on its last earnings call that it will continue to grow in the new year (through the first nine months of 2021, Arista revenue was up 27% year over year).  

Along with its hardware, Arista has also been expanding on its library of software solutions for its data center customers. Together, the company provides a full suite of solutions for enterprises looking to build out new capabilities for the digital world, like cloud operation monitoring and security. In total, it makes for an incredibly profitable business. Arista generated $914 million in free cash flow over the last 12 months, a 33% free cash flow profit margin.

As of this writing, the stock trades for 50 times trailing-12-month free cash flow and nearly 42 times next year’s expected earnings. It’s the highest premium Arista has traded for in years, but given the company’s return to double-digit percentage growth, it’s not an unwarranted price tag. This is a great stock to own if you think data center construction, the cloud, and other next-gen web experiences will remain a secular growth trend throughout the 2020s.  

3. Fortinet: A best-in-class play for security

Cloud-based security software has been all the rage since the start of the pandemic. Firms like CrowdStrike and Zscaler have been top performers in the cybersecurity industry. But Fortinet, often considered a “legacy” security firm, is no slouch. For every cloud service, a data center is doing the work somewhere, and that physical asset needs to be secured as well.

Fortinet designs some of the top chips on the market for this purpose. Even during lockdowns and corporate freezes on some spending in year one of the pandemic (2020), Fortinet’s hardware sales kept growing. And then in 2021 as data center upgrades picked up pace, the company’s product sales segment accelerated (up 40% through the first nine months of the year).

But let’s not pigeonhole Fortinet as a hardware company. In fact, nearly two-thirds of its revenue is derived from services — recurring and very sticky software-based sales that get packaged with the company’s best-in-class equipment. Even as cybersecurity needs have evolved with proliferating use of the internet, Fortinet has adapted and maintained fast and steady growth for years. Development of a new wave of IT services bodes well for the company’s continued success.  

As can be expected from a company that has a long track record of profitable growth, Fortinet stock can be purchased for a premium 48 times trailing-12-month free cash flow and 79 times next year’s expected earnings (a higher multiple for next year assumes the company invests heavily in research and development in 2022). Nevertheless, I still like Fortinet for the long haul. Expect some turbulence after shares more than doubled in 2021, but if you are focused on the firm’s potential over the next five-plus years like I am, this top data center security play deserves attention.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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