The 3 Best Stocks to Invest in Hardware

By Markets Fool.com

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Hardware is a large and diverse category, encompassing many different things, including PCs, tablets, smartphones, and smart gadgets of all kinds. There are quite a few different ways for investors to play hardware. Below are three stocks that offer exposure to the actual physical side of the tech universe.

Apple has the most profitable hardware in the world
Is Apple (NASDAQ: AAPL) a hardware company? Or a software company? Steve Jobs argued that Apple was a software company that just happened to make hardware. "A Mac is OSX -- in a beautiful box -- but it's [just] OSX," Jobs said, in a joint interview with Bill Gates in 2007.

Nevertheless, Apple doesn't actually sell its software -- at least not directly. When consumers purchase Macs and iPhones, they're buying hardware, even if they are primarily purchasing them for the software (OSX and iOS, respectively). Apple derives about 90% of its revenue, and virtually all of its profit, from hardware. iPhones compose the overwhelming bulk of its sales, with the Mac and iPad coming in a distant second and third, respectively.

And while Jobs believed that Apple was fundamentally a software company, selling hardware remains the key to Apple's overarching business philosophy. Unlike competitors Microsoft and Google, which build platforms for third-party hardware companies, Apple believes its software can only excel when it's built in-house alongside its hardware. Apple may be letting third parties create bands for the recently released Apple Watch, but consumers can only buy the Apple Watch from Apple itself (in contrast to Android Wear, which is available from a wide variety of different vendors) Its revenue mix may shift -- perhaps one day, in the distant future, Apple Watch will overtake the iPhone -- but Apple seems committed to hardware for the long haul.

In the interim, there's many reasons to like Apple stock, including its excellent balance sheet and stellar demand for the iPhone 6. Apple's smartphone business has never been stronger -- its last two quarters were the best in the iPhone's history -- and Apple continues to return capital to shareholders. In April, it pledged to spend $200 billion on buybacks and dividends by the end of March, 2017. Unfortunately, Apple has offered up little in the way of hard numbers on the Apple Watch, but has said only about 20% of iPhone owners have upgraded to an iPhone 6 or iPhone 6 Plus. Baring a drastic change in the smartphone market, Apple could continue to sell millions of iPhones going forward, and continue to generate billions in the process.

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Hewlett-Packard will offer investors something close to a pure-play hardware company
There's more to Hewlett-Packard (NYSE: HPQ) than just PCs. Later this year, the company plans to cleave itself in two, splitting into HP and HP Enterprises. The latter will be composed of Hewlett-Packard's software and services businesses; the former, Hewlett-Packard's hardware businesses.

As it stands, Hewlett-Packard is one of the largest makers of traditional PCs in the world (number two according to research firm IDC). In its most recent quarter, it derived about one-third of its revenue from its Personal Systems (read: PCs) business. HP will also include Hewlett-Packard's printer business, which generates less revenue than its PC business but is higher margin. When combined, the two businesses brought in just slightly more than half of Hewlett-Packard's revenue and earnings last quarter.

Hewlett-Packard has many competitors in the PC hardware business, but most of them are either listed on foreign exchanges (Lenovo) or are private (Dell). If you want to invest in a pure hardware company, you could purchase shares of Hewlett-Packard now, selling off the shares of HP Enterprises you receive after the split, or simply wait for the split to happen and then buy shares of HP.

There's reason to believe that the new, hardware-focused HP could be a strong performer, and that current Hewlett-Packard shareholders will benefit from the split. Hewlett-Packard currently trades with a below market multiple (its trailing price-to-earnings ratio is, as I write this, around 12.5) and given the ongoing declines in the traditional PC industry, post-split HP is likely to trade even cheaper still.Despite increasingly powerful mobile devices, there's an enormous market for PCs -- more than 300 million of them were sold last year alone. Hewlett-Packard has yet to lay out the exact details of the firms' operating profiles -- on its last earnings call, it announced it would do so later this year -- but new HP is likely to be a company focused on returning capital to shareholders. If the PC market stabilizes, HP could be strong performer.

Best Buy is an indirect way to get exposure
Lastly, there's Best Buy (NYSE: BBY), one of the only pure-play electronics retailers left. Best Buy doesn't make any hardware itself, but it sells plenty of it. Last quarter, 78% of Best Buy's revenue came from the sale of consumer electronics and mobile gadgets, including smartphones, PCs, tablets, game consoles, and TVs, among many other products.

Many of the companies that make these products are listed outside of the U.S. (LG, HTC) or are private (Jawbone, Belkin). They may be divisions of much larger companies (like Nest and Google), or relatively insignificant portions of their companies' bottom lines (like Microsoft's Surface Pro). In all of these cases, it's hard -- or even impossible -- for investors to gain exposure. Best Buy, then, offers an interesting secondary play on hardware.

Obviously, Best Buy faces competition, and while there's a lot that it can control, it's success ultimately depends on hardware manufacturers' product cycles, and consumers' demand for that hardware. That demand has been relatively tepid in recent quarters -- according to research firm NPD, sales of consumer electronics fell 5.3% on an annual basis from the middle of February through beginning of May -- but could be poised for a rebound.

If new product categories like wearable devices (smartwatches and fitness trackers), smart home gadgets, and set-top boxes stoke consumers' demand for hardware, Best Buy should see an upturn in its sales, and a corresponding increase in its profitability. Although Best Buy's sales have actually contracted in recent quarters (down about 1% on an annual basis last quarter), its profitability has increased as it has successfully reduced its costs. A leaner Best Buy could be a top way for investors to play a stronger hardware market.

Bonus: Fitbit should go public in the near future
Investors can't buy shares of Fitbit just yet, but they should be able to later this year. The maker of popular fitness trackers has filed for an IPO, and should begin trading on the New York Stock Exchange later this year. Almost all of Fitbit's revenue comes from the sale of hardware. To date, it's sold nearly 21 million fitness trackers, including the Fitbit Charge and the Fitbit Surge.

There's some evidence that Fitbit may begin diversifying its revenue stream, branching out into different sorts of products but remaining true to its hardware roots. Rival Jawbone has sued Fitbit, alleging that the latter poached the former's audio engineer for his help in developing forthcoming products.

Fitbit is profitable, and 21 million is a drop in the bucket compared to the potential market (there are more than 200 million adults living in the U.S. alone). If it convince more consumers to purchase and use its fitness trackers, it could become one of the more attractive investments in the hardware space.


The article The 3 Best Stocks to Invest in Hardware originally appeared on Fool.com.

Sam Mattera has no position in any stocks mentioned. The Motley Fool recommends Apple, Google (A shares), and Google (C shares). The Motley Fool owns shares of Apple, Google (A shares), and Google (C shares). Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.