2023-06-20 01:19:22 ET
Summary
- I think Arista Networks is expected to maintain its leadership in the 800 Gbps and 1.6 Tbps switch market over the next decade, benefiting from AI Networking and AI Spine.
- The company's strong financials, including a robust margin profile and significant cash reserves, position it well to withstand any recessionary macro environment.
- Despite near-term uncertainties associated with cloud computing, Arista is given a "Buy" rating, with a fair value stock price of $187 estimated using a two-stage DCF model.
In January 2015, I published an article about Arista Networks ( ANET ): Arista Networks: Shining Bright Like A Diamond Amid Cisco Litigation when its stock price was $16.32. Eight years later, with the stock price having multiplied tenfold, I believe it is opportune to provide an update on Arista in the new AI Era.
As my previous article forecasted, Arista has gained a significant market share in the high-speed data center switch market at the expense of Cisco ( CSCO ) in the past several years. I anticipate that Arista will continue to maintain their leadership in the 800 Gbps and 1.6 Tbps switch market over the next decade. The growing megatrend of AI Networking and AI Spine would equip Arista with another avenue for future growth.
Key Growth Drivers
Gaining Shares in the High-Speed Data Center Switching Market: Over the past few years, Arista has gained notable market shares in the 100 gig data center switching market, and more recently in the key 400 gig data center market. Cisco has consistently lost market shares to Arista in my view. The chart below illustrates the market share landscape in the 10GbE and Higher Switch market, excluding blade switches.
Crehan Research Datacenter Switch Market Share Report 4Q’22
Arista has experienced multiple cycles in the 400 gig switch market, and their exceptional execution has enabled them to maintain their position as the market leader. Currently, Arista is actively investing in their 800 gig switch technology. In my opinion, the introduction of the 800 gig data center ethernet switch will significantly contribute to Arista's growth over the next decade.
Dell’Oro January 2023 - Long Term Ethernet Switch Forecast
Megatrend of AI Networking and AI Spine : Arista primarily operates in two key markets: data center and campus markets. The data center switching market has experienced significant growth due to increased spending on cloud computing and investments by large enterprises. Over the next decade, both cloud computing and enterprise data centers will necessitate AI networking and AI Spine technologies, including cognitive adjacencies and cognitive networks.
In recent earnings calls, Arista revealed that AI networking is still in its early stages. Currently, in high-performance computing cases, there is roughly a 50-50 split between Ethernet and InfiniBand, which are pre-AI technologies. However, Arista believes that AI will become critical and embedded in all business processes.
In terms of AI wallet share, it is estimated that 80-90% of the wallet share will be dedicated to processors. If data center and large enterprise customers are fully vertically integrated in computing technology, it may not present significant growth opportunities for Arista. However, if these customers choose a horizontal best-of-breed approach, Arista will become highly relevant. Considering the complexity of AI networking, it is argued that most customers would choose horizontal integrated technology for their AI deployments.
Arista's flagship AI platform is the 7800, and the company has conducted extensive simulations on how it works with GPU clusters and different types of network interface cards. Arista believes that the next 2-3 years will be crucial for experiencing technological advancements and achieving mass production.
Growing Software & Service : Services and software support renewals currently contribute approximately 13.5% of Arista's revenue, and they possess high margins. Software-as-a-service offerings can deliver zero Trust Networks, improve deployment designs, and enhance visibility and observability. In my opinion, services and software will grow at a faster rate than the rest of the hardware business, leading to an increased margin profile for Arista over time.
Why I think Arista can continue to win 800 gig switch competition?
I have always been asked why large technology companies cannot sustain their technology over time. Before I switched my career to the investment field 15 years ago, I worked in the technology industry for 10 years. From my experience, the main reason lies in the architecture of the software/hardware. When designing a product with embedded software, the software architecture needs to be carefully considered. This architecture determines how the software can evolve in the future as other technologies progress. While features can be added to the software, the architecture itself cannot be easily changed going forward. This explains why Oracle is losing market share to cloud database vendors, why IBM Mainframe struggles to adapt to the cloud, and why Intel's CPUs cannot compete with GPUs.
Arista initially built their product, encompassing both hardware and software, with a focus on the cloud and data centers. Their 400G and 800G switches are easy to deploy in cloud environments and can be easily scaled to meet the growing demands of cloud computing. In contrast, Cisco's switches dominated the traditional on-premises world. They are costly and complex to deploy, requiring Cisco-certified technicians to maintain and design the network. While this structure worked in the past, it is not well-suited for the cloud and AI era.
While Arista continues to expand their portfolio with 100G and 400G products, they have also introduced their first one-rack unit 25-terabyte product this year, featuring 800-gig ports that can be broken out as 2x400-gig. These products have significant use cases and are ideal for high-speed applications such as AI. Arista's operating system, EOS, is a resilient and high-quality network data lake-based system that has matured over time, now supporting cloud-scale operations with multiple copies of the internet routing tables. In my opinion, Arista is way ahead of the game in the new AI era.
Near-term Outlook and Risks
Weakness of Data Center Spending : the current macro environment is generating uncertainties regarding capital expenditure spending among large enterprises, particularly in the data center sector. Arista operates in both the hyperscale and cloud segments of the business, which can be more cyclical compared to other sectors.
During a recent earnings call, Arista acknowledged the potential uncertainties surrounding cloud spending in 2024, and they expect to gain more visibility on this matter by late this year. However, despite these challenges, Arista remains committed to targeting 20% growth from FY20 to FY25.
I estimate that cloud titans, including Microsoft, Meta, and Amazon, represent around 40% of Arista's group sales. I haven't seen any evidence that these cloud titans have started to cut their capital expenditures. Even if there is a macro downturn in the near future, Arista's ability to gain shares in the 100G and 400G switching markets can enable them to weather the slowing demand environment, in my opinion. Additionally, I believe a significant slowdown in cloud migration is unlikely as it is a megatrend, and cloud workflows actually reduce expenses for enterprises over time. Many enterprises need to invest in cloud, AI, and data analytics to maintain a competitive advantage. All in all, I believe the near-term risk is manageable for Arista.
In terms of the near-term outlook, Arista endorsed the consensus of 26% annual growth, aiming to achieve approximately $5.5 billion in revenue by FY23. Additionally, they anticipate that the growth of Cloud Titans will moderate compared to the triple-digit growth experienced in FY22.
Competition from Cisco Nexus 9800: Cisco has designed the Nexus 9800 for core/DC switching solutions, making it a direct competitor to Arista's 7800 series. The Nexus 9800 boasts 400G readiness and 800G capabilities, along with a power-efficient distributed architecture. However, I believe that deploying the Nexus 9800 can be quite expensive, and customers may find it challenging to expand its capacities. In contrast, Arista's products are more affordable and easier to deploy. Arista's Extensible software is highly convenient and user-friendly, allowing for a smooth start, in my opinion.
In addition, Arista boasts a robust margin profile, with approximately 60% gross margin and 40% operating margin. Moreover, as of Q1 FY23, they had $3.33 billion in cash on their balance sheet. These strong financials position them well to withstand any recessionary macro environment, in my view.
Valuation
A two-stage DCF model is used to estimate the fair value of Arista’s stock price. We assume Arista will grow their top line by 20% in the next four years, then moderate to 15% from FY27 to FY32. Their operating margin is estimated to expand by 50bps per year driven by the operating leverage. The free cash flow conversion is estimated to low 20s in the model.
In addition, the model uses 10% of WACC, and 4% of terminal growth rate.
DCF Model-Author's Calculation
In the model, the present value of the Free Cash Flow to the Firm (FCFF) over the next 10 years and terminal value are $15 billion and $38 billion, respectively. As such the total enterprise value is estimated to be $53 billion. Adjusting the gross debt and cash, the fair value of Arista’s stock price is $187, per my estimate.
DCF Model-Author's Calculation
Conclusion
When I first published the Arista article on Seeking Alpha eight years ago, I received lots of criticisms. As Benjamin Graham said, in the short term the market is a popularity contest; in the long term it is a weighing machine. I take a long-term view when conducting fundamental analysis, and short-term fluctuations or headwinds can create tremendous investing opportunities.
I believe that Arista will continue to gain market share in the high-speed data center switching market, and their technology is well-positioned for the 800 Gbps and 1.6 Tbps switch market in the coming decade. Furthermore, in my opinion, Arista is poised to benefit from the megatrend of AI Networking and AI Spine, and the increasing mix of software and services has the potential to expand their margins. While I hold an optimistic view of their future growth, it’s worth noting that there may be some near-term uncertainties associated with cloud computing. Overall, I would give Arista stock a "Buy" rating.
For further details see:
Arista Networks: AI Networking In The New Era