2023-03-23 12:00:00 ET
Summary
- Arista Networks is a cloud-focused networking solution provider that has a massive risk and opportunity.
- ANET is growing rapidly, but its growth rates will be choppy going forward, depending on customers' capex cycle.
- Altogether, I'm bullish on ANET as I believe its valuation is very compelling.
Investment Thesis
Arista Networks ( ANET ) is a cloud networking platform. The business sells hardware to two large key customers.
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.
On balance, I find myself positively compelled toward ANET.
The Problem or the Opportunity?
42% of ANET's revenues come from Microsoft ( MSFT ) and Meta ( META ). Massive concentration. Is that a problem? Well, it's not a problem .
But at the same time, recall that both Meta and Microsoft have been increasing their spend on ANET. Now, consider this, is having the bluest of blue chips as your customers going to make it easier to sell to other tech companies seeking to embrace AI? Or is it going to be more difficult to upsell to other customers? This rhetorical question answers itself.
I spend a lot of time reading through earnings calls, and as you'd expect, since the Street got AI-fever, suddenly every CEO and his dog are talking about how their business benefits from AI. I get it, there's a lot of hype around.
But at the same time, I believe that indeed in the past year or so, there had been some level of AI percolating through companies, even if it might have just been a small portion of many companies' underlying operations.
But what you care about as an investor is the nascent opportunity . You want to position yourself at the start of the opportunity. Not when everyone knows about it, and it's amply reflected in the fundamentals of companies and even more fully reflected in their valuations.
Revenue Growth Rates Will be Choppy
This is the fact of the matter, ANET is essentially a hardware business with software layered on top.
Meaning that the business is prone to be volatile due to the cyclical capex cycles of its "cloud titan" customers, not to mention that once ANET has finished fully penetrated MSFT, MSFT is likely to slow down its purchases from ANET.
In fact, that's something that I believe is worthwhile being mindful of. MSFT's capex cycle could slow down, and given ANET's exposure to MSFT, at just over a quarter of ANET's revenues coming from MSFT, any slowdown in MSFT could have dramatic implications for ANET. Or even more subtly, MSFT may request pricing concessions.
Further, as the graphic above is practically shouting out, Q1 2023 will be the last easy comparable quarter for 2023. After that, its comparable growth rates become increasingly more challengingly to positively impress investors.
Now I want to move the discussion to this consideration.
As an investor, one of the best setups you have is represented in the chart above. What you want as an investor is the sell-side consistently upwards revising their revenue estimates over time. You want the sell-side pumping your stock.
Provided the valuation makes sense, if the business will be stronger over the next two years, and the sell-side is gushing over your company, that's probably one of the best setups you can have.
Now, we'll turn our focus to ANET's profitability profile.
Profit Margins to Die For
ANET's 2022 clean GAAP profit margins were 35%. This figure is weaker than Broadcom ( AVGO ), whose clean GAAP operating margin for the quarter that ended January 2023 was 46%.
But ANET's clean GAAP profit margins are meaningfully higher than Cisco's most recent quarter of 26%. What's more, the graphic below shows ANET is taking market share from Cisco.
Hence, not only is ANET taking market share from Cisco, but it's doing so without sacrificing profitability.
The Bottom Line
ANET is cheaply valued at less than 30x this year's non-GAAP EPS figures. Here, I've not overstressed ANET's stock valuation, as I don't believe that is where the bull or bear case is found.
I believe everything boils down to how much one believes that M&M as ANET calls the two "cloud titans" continue to invest in AI and make hardware purchases from ANET.
Or put another way, will ANET be able to find other large enterprises seeking to ramp up their AI infrastructure, before M&M slow down their purchases? Frankly, that's the ultimate thesis here.
For further details see:
Arista Networks: AI Pick-And-Shovel Business