2024-01-10 12:13:51 ET
Summary
- With a debt-free balance sheet, ANET's stock valuation stands at 26 times its forward non-GAAP operating profits, presenting an appealing investment opportunity.
- The company's strategic move to consolidate cloud and AI titan customers into a single sector, contributing over 40% to the total revenue mix, reflects adaptability to market trends.
- Despite near-term challenges, including supply chain uncertainties and evolving customer spending patterns, ANET is still highly profitable.
Investment Thesis
Arista Networks ( ANET ), a leading provider of advanced networking solutions, is likely to have a better 2024 than investors presently expect.
Even though the company has already been performing very strongly in 2023, I believe this stock could continue to do well in 2024.
More specifically, I make the case that this debt-free company, priced at 26x its forward non-GAAP operating profits is a compelling investment, well worth considering.
Rapid Recap,
Back in October, I said in a bullish analysis ,
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.
In fact, it should be noted that I've been bullish on Arista Networks over the past 12 months and this is the stock's performance.
Despite the stock being up 45% since I first started recommending this stock, I remain bullish on the stock. Here's why.
Arista Networks' Near-Term Prospects
Arista Networks specializes in providing advanced networking solutions for businesses. Essentially, they offer high-tech systems that help companies manage their computer networks more efficiently. Arista's focus is on making the communication and flow of data between computers and servers within an organization faster, more reliable, and easier to control.
They excel in developing innovative technologies like Extensible Operating System and CloudVision, which act as the backbone for modern networks. In simpler terms, Arista Networks is in the business of making sure that information travels smoothly and securely across the digital highways within a company's infrastructure.
In the near term, Arista Networks stands at the forefront of a promising trajectory, backed by robust financial results in the last quarter.
Arista's strategic decision to consolidate cloud and AI titan customers into a single sector, projected to contribute over 40% of their total revenue mix, reflects a keen understanding of evolving market trends. The focus on AI networking and cloud services positions Arista favorably to capitalize on the increasing demand for cutting-edge technologies. Notably, the company's commitment to a single Extensible Operating System and CloudVision stack underlines its dedication to providing a unique foundation with architectural superiority. With a predicted annual growth rate of 33% for 2023 and a consistent improvement in gross margins, Arista is showcasing resilience and adaptability, setting a gold standard in the industry.
However, Arista Networks is not without its near-term challenges. The intricate nature of the current supply chain environment and lead times introduces uncertainties that demand careful navigation. While improvements are anticipated in 2024, the company needs to maintain a delicate balance to avoid creating redundant customer inventory and optimize resource deployment efficiently. The challenge lies in ensuring a seamless transition to normalized supply chain conditions while maintaining operational excellence. Moreover, the evolving landscape of customer spending patterns, particularly in the cloud and AI sector, adds an extra layer of complexity. Arista must continually adjust strategies to meet market demands and balance traditional infrastructure spending with the heightened emphasis on AI clusters.
Given this context, let's discuss its financials.
Revenue Growth Rates Coming Strong
Arista Networks has been raising its outlook for the past couple of quarters. Up until Q3 it had been expected that the strong growth the company exhibited from the back end of 2022 into H1 2023 was going to tail-off and fade lower.
However, this has demonstrably not been the case as Arista's Q4 guidance now points to grow by approximately 22% y/y. And what's particularly bullish is that this is during a period when inventories are still being digested at its cloud titan customers (this predominantly means Meta ( META ) and Microsoft ( MSFT ).
Consequently, this leads one to believe (or hope) that as a new cycle server adoption cycle resumes throughout the sector, there may be a further acceleration in Arista Networks' revenue growth rates.
Or perhaps, instead of an acceleration in its growth rates, we can simply come to rely on Arista to continue growing at around mid-20s% CAGR in 2024. After all, once Arista gets past the tough comparable period of Q1 2024, the remainder of 2024 starts to sequentially ease up making the quarterly comparisons easier.
After all, when it comes to investing you must always try to think about what the person looking at the stock 1 year from now will be thinking, as they look ahead themselves at that time. To put this more concretely, rather than looking at a company with 4 or 5 quarters of decelerating revenue growth rates, they'll be appraising a company where its decelerating quarters are in the rearview mirror, and they'll be eyeing up a company that has "turned" around its prospects.
This is simply a consequence of the comparables easing up. On top of that, layer a positive narrative together with a rosy outlook and you'll see the stock continue to perform relatively strongly.
Let me add some more context, see below.
Analysts following the company expect to see around the mid-teens growth rates next year. This is meaningfully less than my own expectations of mid-20s%. So, perhaps I'm overly bullish? Perhaps, it's difficult to know at present.
But what I do know is that there's a very low likelihood that Arista's Q2 and Q3 2024 will see less revenue growth rates than Q1 2023. For this, consider what we've already discussed above. Therefore, there's a notable noteworthy and significant likelihood that analysts will be raising their consensus revenue estimates for Q2 and Q3 2024 as we make some more progress into 2024 and analysts get more "visibility" into those quarters.
Given this chain of thought, let's discuss its valuation.
ANET Stock Valuation -- 26x Forward Operating Profits
Let's make a few assumptions. Let's assume that in 2024 Arista's revenues grow by 20% CAGR. This is higher than what analysts expect, but lower than what my instinct tells me is likely to be the end result, given the strong demand for its products were are clearly witnessing right now.
This means that in 2024, Arista would deliver $7 billion of revenues. However, let's assume that on the back of slightly more subdued growth, Arista doesn't quite see as strong operating margins. This means that rather than delivering about 43% of non-GAAP operating margins, it compresses slightly down to 41%.
To reinforce my assertion, consider what Arista's management said back in their Q3 earnings call,
[...] is we have been seeing [gross margins] incrementally improve as we've gone through the year. We expect it to stabilize. So not that we expect it to go down next year, but more that it will stabilize.
Moreover, at the start of 2023, Arista's gross margins stood at 59.5% and are likely to end up Q4 at around 63% or even a smidge higher.
Taking this guidance on board, I believe we could see Arista delivering about $2.9 billion of non-GAAP operating income. This would put the stock right now at 26x this year's non-GAAP operating income.
ANET's multiple has obviously been expanding throughout 2023, as has the rest of the tech sector's multiple. But I don't believe that paying around 26x non-GAAP operating profits is a particularly stretched valuation for a company that could be growing at 20% CAGR over this year.
The Bottom Line
Arista Networks appears poised for a robust performance in 2024, building on its already strong showing in 2023.
Despite a 45% stock increase in the past 12 months, the company remains an enticing investment opportunity, given its debt-free balance sheet and the current stock valuation at 26 times its forward non-GAAP operating profits.
The strategic consolidation of cloud and AI titan customers into a single sector, representing over 40% of the total revenue mix, showcases Arista's adaptability to market trends.
With a focus on AI networking and cloud services, coupled with a commitment to innovative technologies, Arista is well-positioned to capitalize on the increasing demand for advanced networking solutions.
All in all, I believe this is likely to be a rewarding investment in the next 18 months. I would hope to see the share price go to $320 per share, assuming the multiple on the stock remains unchanged.
For further details see:
Arista Networks: Debt-Free, Priced At 26x Operating Profits