Another Semiconductor Stock Is Headed to the S&P 500

0:01Matt Frankel:There's another semiconductor stock headed for the S &P 500. You're listening to Motley Fool Hidden Gems Investing. Welcome to Motley Fool Hidden Gems Investing. I'm Jon Quast and I'm joined today by contributors Matt Frankel and Rachel Warren. We're going to dip into our mailbag today, not once, but twice. But first, we wanted to start with our lead story, and that is about once a quarter, the S &P 500 removes some companies from the index and adds other companies. This is an index that tracks roughly 500 of the largest, most profitable U.S.-based companies. There are some times where a company gets acquired or something like that, and then another company is added in between the regular rebalancings.

0:49Matt Frankel:But we had this regular one and Pool Stock and Campbell Soup Company are out as a shareholder of Pool and a lover of goldfish crackers. I'm disappointed with that. But we have a couple of new ones heading in, and that is Marvell and also Flex. And so while the indexing itself isn't really something material that we foolish investors really base an investment thesis on, Sometimes it is fun to bring a new stock to our attention as they get added to the large index here. And so we thought it would be fun in this episode to talk about these. And I'm going to start here with Rachel. We want to talk about Marvell going into the index.

1:28Matt Frankel:And basically, my question here for Rachel is, what is Marvell? What does it do? And what is so interesting about the timing here is NVIDIA CEO Jensen Wong says he believes that this can be a$1 trillion company someday. So I want you to speak to that as well, Rachel. Yeah, I do think that this could very much qualify under the moniker of a hidden gem. So Marvell Technology, for anyone who's not familiar, this is a data infrastructure powerhouse. They specialize in the high-speed optical interconnect chips and custom AI silicon that's really essential in today's day and age for transmitting data across massive server clusters.

2:05And as you noted, John, Jensen Huang recently declared Marvell the next trillion-dollar company. And he said this because as AI models scale, computing has to be distributed across an entire data center. So this makes Marvell's high bandwidth connectivity a key solution to the industry's biggest physical bottleneck, which is data movement. Now, you might be thinking a$1 trillion milestone sounds outrageous for a company that's currently valued in the$200 billion market cap range. But I think that Huang's prediction is actually a reasonable long-term thesis. It's also backed by NVIDIA's own$2 billion equity stake in Marvell.

2:43That's something that's very important to note as well. But Marvell's path to$1 trillion, there's a few key drivers here. You know, there's the massive dual-engine revenue expansion. Hyperscalers are using Marvell to design custom AI chips. That's a business that's projected to cross$10 billion in revenue by the company's fiscal 2029. The optical business is growing at a 70 % plus growth rate, and that's as they're linking distributed GPU clusters at the speed of light. So if Marvell stains this very robust growth trajectory in the mid-double digits, if they're able to hit that estimated$50 billion in revenue, $25 billion in EBITDA by 2031, you could be looking at a premium of about 40 AI infrastructure multiple.

3:27But I think that you could see where there is a mathematical justification for that trillion-dollar valuation. Obviously, this addition to the S &P 500, it triggers mandatory index fund buying. And I think it also cements its role in global AI architecture. So it will be interesting to see whether the company hits this$1 trillion milestone. Whether it does or not, I think we are very much looking at a company that is playing an indispensable role in the AI infrastructure build out. And I think that's a very exciting thing to watch.

3:56Matt Frankel:Yeah, as we're using the term hidden gems, not necessarily a small company, but one that might not be consumer facing very often. And so it's hidden in that sense. Most people are unaware of the company and what it does. And so Marvell would qualify under that. But we're also looking for these companies that can deliver for shareholders. And you're pointing out basically that you think it is realistic that this company could be a trillion dollar market cap company someday. That would be based on these projections, right? I mean, the 2031 timeline, that would be if it could reach a trillion by then, by the time it's making$25 billion in EBITDA.

4:32Matt Frankel:I mean, this would be a four-bagger in five years. Let's have a little fun here. Matt, would you agree or disagree that it has a realistic path to this in the next five years?

4:43Jon Quast:A chance, yes. A realistic path, maybe. And there's a lot we don't know about what AI infrastructure will look like in 2031. And what I mean by that is right now, demand is soaring for this. I mean, Alphabet's AI spending is double what it was last year. Other companies, It's the same. Who knows if the demand is going to keep growing kind of at an exponential pace for the next five years? We just don't know. Even if it does, are we going to be able to solve the energy problem that it would require to keep building out all this infrastructure? AI could get more efficient. Every new technology gets more efficient over its first few years.

5:15Jon Quast:We could do the same amount of work with fewer AI chips by 2031. We don't know. If Jensen Huang's right, and this is really the future of data movement, and we get the appropriate tailwinds, yes, a trillion dollars is possible. It's not my base case for this company.

5:33Matt Frankel:Yeah, I appreciate that little bit of pushback. It's always good to balance our perspectives on a company. But let's go ahead and turn now to Flex, the other company that is being added here to the S &P 500. Basically, I want you to talk, Matt, explain to us what Flex is. and whether or not you think it could be a hidden gem stock?

5:51Jon Quast:Well, if you haven't heard the company's name, it's probably because it used to be called Flextronics. So it's one of the largest electronic manufacturing service businesses, also abbreviated as EMS, even though that does stand for more than one thing. One of the largest companies of that kind in the world. Think of Flext as a factory that serves electronics companies that design products but don't want to manufacture those products themselves. The big, you know, customers send their designs to Flex, they make the product, they ship it. The big tailwind right now is their AI data center business, kind of like everything else here.

6:25Jon Quast:It's a big operation. They make their power management, they make power management products, cooling products, electrical infrastructure products for data centers. It's a big company. This is, you know, a lot of electronics manufacturers don't make their own products. Flex did$28 billion of revenue in its last fiscal year. It's a highly profitable business. it's grown its earnings at a double digit rate for the past six years in a row and management expects acceleration because of this ai data center part of their business in the current fiscal year which their fiscal year runs through march 18 revenue growth 32 earnings per share growth is what's expected right now the most interesting development that i think could make this a hidden gem investment is that flex is spinning off its cloud and power infrastructure business the most exciting part of it the other part of flex's business is just electronics manufacturing, very low margin, very predictable single digit revenue growth over time.

7:19Jon Quast:So the rapidly growing part is spinning out. So is it a hidden gem? Maybe. The stock has more than tripled already over the past year. The forced index buying, which Rachel correctly referred to with Marvell, could give it a nice little short-term lift, but it's not going to be a long-term catalyst. The stock trades for about 35 times forward earnings. And like I said, historically, it's a low margin, modest growth business. The spinoff is the wild card. That AI infrastructure business could command a very high multiple as a standalone business. They're expecting that part to grow by 65, 70 % this year.

7:51Jon Quast:We've seen some much crazier valuations than 35 times earnings for businesses that go into that category. Still, as it is now, it seems a little expensive for new buyers, and I probably wouldn't buy at these levels. But if we saw the 20%, 30 % pullback that we've seen in other similar businesses, I might become very interested in this.

8:12Matt Frankel:Well, and thanks for pointing out that spinoff because one of the things that we do look for in a hidden gem, a potential hidden gem, is something that's misunderstood by the market. And certainly a spinoff can be something that is misunderstood when you're trying to calculate that value. However, you're alluding to the fact that perhaps you believe that this stock is overvalued going into it and that may diminish some return potential here. So, Rachel, I want you to agree or disagree with Matt's premise here of FlexStock being slightly overvalued, overvalued. What do you think? I think it's possible that it's overvalued, but I think what might justify that valuation as we move forward is how the business is fitting itself into the reality of where the economy is heading.

8:57You know, it had been this kind of low margin contract manufacturer that just built electronics for other brands. They've been really transforming and trying to rebrand themselves into this very sophisticated engineering partner for the mega cap tech giants and become one of those companies that is one of the more indispensable backbones of the AI boom. I think it will be very interesting to see if and how, you know, that spinoff occurs. But I think as we're really seeing that shift from customer gadgets to focusing on the complex industrial tech, you know, manufacturing that massive power infrastructure, advanced liquid cooling systems required to keep modern generative AI data centers from overheating.

9:34I think that's where their business model has, you know, developed into kind of the most fascinating part of where it needs to be looking ahead over the next, you know, five to 10 years. So I think if they can continue to capitalize on that shift, I think we might see the valuation be justified. As it stands right now, though, I tend to agree with Matt. It is a little bit overvalued. All right.

9:55Matt Frankel:Well, when we come back, we're going to pivot and we're going to go into the mailbag to talk about a health care stock question that was submitted. You're listening to Motley Fool Hidden Gems Investing.

10:11Study and play.

10:12Matt Frankel:Come together on a Windows 11 PC. And for a limited time, college students get the best of both worlds. Get the Unreal College Deal. Everything you need to study and play with select Windows 11 PCs. Eligible students get a year of Microsoft 365 Premium and a year of Xbox Game Pass Ultimate with a custom color Xbox wireless controller. Learn more at windows.com slash student offer. While supplies last, ends June 30th. Terms at aka.ms slash college PC. Welcome back to Motley Fool Hidden Gems Investing. We certainly love taking mailbag questions whenever we can. And this question I wanted to throw to Rachel here because healthcare is kind of a little bit more her circle, her area that she spends a lot of time for sure.

10:56Matt Frankel:And so let me this question actually has two parts. So I'm just going to read the first part here and then I'll read the second part in a bit. But this is from Drew says, love the podcast. Thank you very much. I've been highly unimpressed by Bristol-Myers Squibb for years now. Stock remains in the doldrums. I had high hopes when it acquired Celgene in late 2019, which seemed brilliant for its products and pipeline and got it cheap, but they've really struggled since, it seems. Thoughts? And, of course, Drew here is referring to the$74 billion acquisition that happened in 2019. So we're past the five-year mark, and Bristol-Myers stock is up less than 1 % since then.

11:35Matt Frankel:And why hasn't this acquisition helped the stock? Yeah, it's a great question. I think it's really the exact tension that's frustrated investors in this business for years. So the Celgene acquisition, it delivered what was at the time really an incredible cash cow for the business. But it also, on the flip side of that, it saddled Bristol-Myers Squibb with massive debt, as well as some structural dependencies that they're still trying to outrun. And one of the biggest challenges that Bristol-Myers Squibb has been facing has been a really brutal front-loaded patent cliff. Now, obviously, patent cliffs are part of the life cycle of every pharmaceutical business.

12:12These are expected. These are planned for many years in advance. But sometimes you see these periods of transition, and that has very much been what Bristol-Myers has been going through. So a lot of the mega blockbusters that used to really anchor the business are facing really aggressive generic competition as those patents have expired. So, for example, their primary cancer asset, Revlimit, saw revenues plummet from over$12 billion down to$3 billion as they are seeing loss of volume to those generic competitors. And that creates a tough timing mismatch because that means that, you know, legacy sales are dropping faster than new drug launches can scale up.

12:51Again, this is not uncommon in the world of pharma, but it is very much the dynamic we've been seeing with Bristol-Myers. Now, I want to say overall revenue has been flat, but internally we're seeing I think the business is hitting a really pivotal turning point. So they had a massive milestone in their recent financial report, their newer growth portfolio. So those more newly launched products led by a few of their rising stars that actually expanded by 12 percent year over year in revenue to more than six billion. So their growth portfolio of these newer assets is out earning their declining legacy assets for the first time.

13:27Now, we're still seeing the stock trading at a very compressed multiple. We've seen a lot of skepticism from the market about their upcoming patent losses, including on major drugs like Eliquis. But I do think for long term investors in the stock, the growth portfolio, I think, over time is going to outmatch the drag from those legacy assets.

13:46Matt Frankel:So basically patent issues, debt being very high, those things are kind of weighing the stock down. The second part here of the question is how would you compare them? So Bristol-Myers Squibb, how would you compare them to Pfizer and other competitors? Yeah, I mean, these are different businesses in many ways. Obviously, they're all navigating industry-wide patent cliffs. Pfizer is a great example of that. I mean, for anyone that's watched that stock, they obviously had to really absorb the steep collapse post-COVID demand for their COVID franchises. But I will note, and I've said this before, Pfizer used that historic windfall of cash and profits from their vaccine, from their antiviral medication to plan for the future.

14:34You know, they famously executed a$43 billion acquisition of the oncology powerhouse Segan. That basically meant they absorbed a massive powerhouse and clinical pipeline in oncology focused on antibody drug conjugates. They actually recently announced a$10.5 billion cancer partnership with a company called Innovent to secure their long-term pipeline runway. So Pfizer is heavily focused on oncology. They've made a range of other acquisitions outside of that space, but they have planned to have eight or more oncology blockbusters in their portfolio by the early 2030s, and they seem well on their way to that.

15:11Now, to compare these businesses a bit, I mean, they both are dividend payers. So Pfizer, its current dividend is just under 7%. Bristol-Myers is around 4.4%. And you look at an oncology giant like Merck, they have a slightly lower yield. I'll note Pfizer has a very, very high dividend ratio. Their payout ratio is about 131%. Bristol-Myers is around 70%. So ultimately, when you're looking at these businesses, it's really important to understand how their pipelines work. It's really important to understand where their competitive advantages lie. A lot of times when you're putting cash into pharma businesses like these, you're really doing it for the dividend payout.

15:52So you really want to make sure that that is safe and well supported by cash and profitability. I think that is very much the case with both Pfizer and Bristol-Myers. But this is not a space for every investor. So it's important to make sure you understand it before you put your capital to work.

16:07Matt Frankel:So let me turn it to you here, Matt, because I know that you like dividends. And we definitely, as Rachel brings up the dividend here, we want to get some more commentary and some thoughts here from a dividend perspective. Both Bristol-Myers and Pfizer would be classified in the high yield category. But is there one of these two that you would prefer as a dividend stock today?

16:29Jon Quast:I am not the most knowledgeable in the pharmaceutical industry. So that was actually a great rundown. I feel like normally when people try to explain pharmaceuticals to me, it's like when I try to explain AI to my grandfather. other. So I'm going to dig in a little bit more on the dividend side because that's what I know really well. So both of these, as Rachel said, are fairly mature pharmaceutical companies. I think it's fair to say that. And it's not just about comparing the dividend yield. If all you want is income, Pfizer all day. But look at their capital allocation preferences. Bristol-Myers, they have a lower payout ratio.

16:58Jon Quast:Their 10-year average is about 40%. I look at long-term averages. Right now, both have high payout ratios artificially because of things like one-time costs related to acquisitions and things to that effect. So their long-term average is about 40%. The dividend is well covered by their current cashflow, even right now. Pfizer not only has the highest yield right now, but they have the more steady dividend payment track record. That's one other thing that I like to compare. They have a long-term average payout ratio of 50 to 65%. So even in what I would call a normal year, they pay out more of their income than Bristol Myers does.

17:31Jon Quast:Bristol Myers has been more acquisition focused and opportunistic other than that big one-time you know, Pfizer deal. So in a typical year, it retains more of its earnings for opportunities like that and to get, you know, to anticipate the patent clip and things like that. Pfizer has slowed its dividend growth recently, roughly 2 % annualized rate since 2020. It seems like it's trying to conserve capital and delever its balance sheet as a priority. So that's all to say, I don't necessarily think one is better than the other for income investors. Pfizer obviously has the higher yield, but for predictability and steadily growing income, that would be my choice.

18:08Jon Quast:If you want a slightly more aggressive growth approach, I think Bristol Myers would fit to that category and still a solid dividend. But like I said, I don't think one is the clear winner here. Both are great options for income investors.

18:21Matt Frankel:Well, it's interesting you highlight one as being more aggressive than the other because after the break, we're double dipping into the mailbag and talking to one of our youngest listeners. you're listening to Motley Fool Hidden Gems Investing

19:00Jon Quast:Gift more and do more together this Father's Day with help from The Home Depot.

19:05Matt Frankel:Exclusions apply. See homedepot.com slash price match for details. Welcome back to Motley Fool Hidden Gems Investing. We do like to make you part of the conversation. So if you have a stock or investing question for anyone on this show, we have different hosts throughout the week, but you can email us at podcast at fool.com and we'd love to read it on air. We'd love to speak to it. We do need you to keep it foolish. If you can keep it short, that's even better. but that email again is podcast at fool.com, podcast at fool.com. And so here's our final segment, our second question of the day. I'm gonna throw this to Matt as our little bit more on the financial planning side of the spectrum when it comes to our contributors.

19:44Matt Frankel:But here's the question here. My name is, and I won't read the name for on air, but I'm 16, I'm from Abu Dhabi and I'm a daily listener. That is incredible. I follow the markets and manage small portfolio built on great by great companies and hold philosophy the fool has preached since before I was born. A question for the show, when you're 16 and your edge is time rather than capital or information, how should that change what kinds of companies you study? Should a teenager's watch list look different from an adult's? So basically here, this question, Matt, is speaking to age-related things when it comes to investing.

20:23Matt Frankel:And as a 16-year-old, which is incredible that they're already taking investing seriously, how should they be thinking about what they should be putting their emphasis on?