2023-10-19 11:46:14 ET
Summary
- Arista Networks' bullish outlook is driven by its focus on AI-related advancements and strong growth rates, although concerns about potential over-earning and customer concentration persist.
- ANET has experienced significant stock volatility but continues to demonstrate robust potential, with its valuation not fully reflecting its promising prospects.
- The current valuation for ANET stands at around 26x next year's EPS, suggesting that the stock remains reasonably priced despite its AI-centric focus.
Investment Thesis
Arista Networks (ANET) helps businesses create and manage advanced networking systems for data centers and office environments. They focus on providing reliable, efficient, and scalable solutions that enable automation and security for network operations.
Back in March , I penned a bullish analysis that said,
The bull case here focuses on the AI theme, plus ANET's rapid growth rates.
While the bear questions whether ANET might be over-earning right now and is left too exposed to any slowdown from either of its two key customers.
Since then, I've been unwavering bullish on ANET, even though the stock has been highly volatile.
Author's work on ANET
But the biggest irony of all is that that same insight could have been said today about Arista Networks. Indeed, I continue to believe that although this investment thesis is not blemish-free, its strong prospects are still not fully reflected in its valuation.
More specifically, I believe that paying around 26x next year's earnings is still a fair entry point into this stock.
Arista Networks' Near-Term Prospects
Arista Networks provides data-driven, client-to-cloud networking solutions for next-generation data center and campus workspace environments. Their architecture, distinguished by a focus on high-quality standards and operational efficiency, is supported by their advanced networking operating system, Arista's Extensible Operating System ("EOS"). Combined with a range of network applications, ethernet switching, and routing platforms employing merchant silicon, Arista offers a cloud networking solution that emphasizes high performance, scalability, and availability.
Their offerings enable network automation, visibility, and security, together with several recent acquisitions further enhancing their capabilities in network security, visibility, and edge threat management.
One bearish concern, but by all means not only one as we'll soon discuss other bearish elements, is that Arista's revenues are about 40% concentrated with Microsoft (MSFT) and Meta (META) spending on products catering to the high-speed data center switching market and cloud-managed wireless networking market. In essence, Arista Networks provides reliable networking solutions but is highly concentrated on its titan tech companies.
In the near term, Arista Networks is likely to benefit from the increasing demand for networking solutions, particularly in the context of AI-driven data centers. With the growing adoption of AI chips and the deployment of advanced networking systems, Arista is poised to capitalize on the evolving market needs, positioning themselves for sustained growth over the next few quarters.
Given this context, let's discuss some of the negative aspects facing Arista.
Revenue Growth Rates Will Remain Moderate in 2024
ANET revenue growth rates
The graphic above points to Arista's best near-term revenue growth rates being in the rearview mirror, at least for now. Arista will report its Q3 results in less than 2 weeks' time, on Monday, 30 October , after hours.
Moreover, Arista faces several challenges. Everyone wants to hear about AI and how much exposure Arista has to AI. But overall, there is a lack of clarity in quantifying the impact of AI on their business due to the complexity of AI use cases and the ambiguity in defining AI-related network requirements.
Further, presently, Arista grapples with supply chain constraints, navigating the 52-week lead time for silicon components, which could potentially disrupt their operations and growth projections.
What's more, during a recent conference , Arista's management openly discusses the potential for 2024 to be a "digestion" year.
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And this is where the plot thickens. Let's assume that analysts' estimates for H1 2024 are more muted than necessary. Let's assume that in Q1 2024 and Q2 2024, Arista's revenue growth rates end up around 10% to 13%. That would be a meaningful improvement relative to current expectations. But naturally, this begs the question, will it be enough?
Will investors continue to chase this stock higher, when the next 2 or 3 quarters or possibly Q4 quarters Arista will be growing significantly slower than its expected Q3 results will be reported in less than 2 weeks' time?
It's one thing to be bullish when the share price is going up. It's quite another to be sitting on a stock that's facing nearly a year of decelerating revenue growth rates.
This leads us to discuss investors' expectations.
ANET Stock Valuation - Still Reasonably Priced
Now, let's discuss the top bullish aspect. I like to use the price-to-sales ratio as a gauge for investors' expectations. As you can see above, earlier this year, this stock was priced at the low of 6x forward sales and it's now priced at 10x forward sales.
This means that its multiple has already expanded by more than 60% in 2023. Now, my next question is this. Should we expect Arista's multiple to expand more, by, say, a further 60% in the next 12 months?
On the other hand, even at 10x forward sales, and despite all the focus on AI's prospects, I don't believe that anyone can objectively declare that Arista's valuation is looking particularly stretched either. After all, over the past 2 years or so, Arista has, for the most part, been priced around 10x forward sales.
So, assuming that Arista's multiple doesn't meaningfully compress in the next twelve months, which I would presume that it won't, particularly if one assumes that Arista's H1 2024 could end up seeing analysts raising their consensus after its Q3 earnings call in less than two weeks' time, then, this stock should continue to be a strong performer.
To put it another way, according to my estimates, Arista is priced around 26x next year's EPS. Not the cheapest stock with exposure to AI-connectivity demand, but far from exuberantly priced too.
The Bottom Line
Arista Networks is a leading provider of networking solutions for data centers. While their AI-focused approach and robust growth rates have garnered bullish sentiments, concerns remain about potential over-earning and dependency on key customers.
Despite the stock's volatility, I maintain a positive outlook on ANET, believing that its strong prospects are not fully reflected in its current valuation. The company faces challenges in quantifying the impact of AI on its business and managing supply chain constraints, which could affect its growth trajectory.
Also, while revenue growth rates are expected to moderate, the stock's current valuation, of approximately 26x next year's EPS, suggests that it remains reasonably priced, providing potential for continued strong performance.
For further details see:
Arista Networks' AI Impact And Perspective On 2024