2023-05-02 16:06:11 ET
Summary
- Shares of Arista Networks plunged on May 2 after the company announced financial results for the first quarter of its 2023 fiscal year.
- This came about despite the company exceeding analysts' expectations across the board and forecasting strong growth moving forward.
- A lofty share price is proving to be prohibitive for those who are long-term, value-oriented investors.
Growth investing can be incredibly rewarding. At the same time, it can also prove to be horribly challenging. Even when things go right, the end result can be pain, whether temporary or permanent, for the investors who follow this approach. This is especially true when you are practicing this investment philosophy during uncertain economic times. A really great example of a company that just came out with fantastic results, but that still fell materially in response, can be seen by looking at Arista Networks ( ANET ), an enterprise that makes its money off of the cloud computing market. Despite blowing past expectations on both its top and bottom lines when it reported financial results for the first quarter of its 2023 fiscal year, shares of the business took a plunge, dropping 13.3% as of the time of this writing. To some, this may be viewed as a good buying opportunity. In truth, for those who are focused on the short run, that very well may be the case. But for those focused on the long haul, I do still think the stock is a bit pricey to warrant to material upside from here.
Stellar results fall flat
If my initial description of Arista Networks seems vague, it's only because I have written about the company in depth previously. I encourage you to check out that article here . That article was published in February of this year and was my first foray into Arista Networks. At that time, I concluded that the company was generating fantastic performance and I believed that trend would continue through at least the 2023 fiscal year. I considered the company a high quality operator in its space, but I also arrived at the conclusion that shares were a bit pricey for me to rate in a bullish way. As a result, I ended up rating the company a ‘hold’ to reflect my view that the stock should generate performance that would be more or less in line with what the broader market would achieve. Since then, after factoring in the 13.3% decline in the company's share price as I write this, the firm has more or less matched this expectation. While the S&P 500 is down 0.6%, shares of Arista Networks have experienced downside of 3.2%.
Given how much shares fell on the morning of May 2, it may seem as though the business reported some really awful results. That couldn't be further from the truth. Revenue for the first quarter of the 2023 fiscal year came in at $1.35 billion. That's 54.1% higher than the $877.1 million the company reported one year earlier. It was also higher than what analysts forecasted to the tune of $40 million. Service revenue during this time was up a modest 17.7%. The real driver was the 61.7% surge that the company saw in product revenue. This, according to management, largely consists of sales of the firm's switching and routing products, as well as related network applications. The spike in this category was due to strong demand for these platforms from across the company's customer base. In particular, ANET noted robot demand from its large cloud customers. Geographically, sales growth was definitely centered on the Americas. Revenue here at home skyrocketed 67.8%, taking sales from this region up from 75.7% of overall revenue to 82.5%.
On the bottom line, the picture for the company was equally impressive. Net profits shot up from $272.3 million to $436.5 million. That's a gain of 60.3%. Naturally, the jump in revenue was the primary driver behind this. On a per share basis, the company went from a profit of $0.85 to a profit of $1.38. This was $0.18 per share above what analysts forecasted. On a non-GAAP basis, earnings went from $0.84 per share to $1.43, with this reading being $0.08 per share above the adjusted earnings per share that analysts expected. Other profitability metrics also increased nicely. Operating cash flow, for instance, rose from $217.1 million to $374.5 million. If we adjust for changes in working capital, we would get a jump from $236.9 million to $455.1 million. Meanwhile, EBITDA for the company expanded from $291.1 million to $505.5 million.
The guidance provided by management was quite rosy. Revenue, they said, for the second quarter of the year should be between $1.35 billion and $1.40 billion. At the midpoint, that would translate to a 30.7% increase over the $1.05 billion reported for the second quarter of the 2022 fiscal year. For the year as a whole, management said that revenue should be about 26% above what it was last year. That should translate to a reading of about $5.52 billion. When forecasting what the future might look like from a profitability perspective, we weren't provided with all that much. At least not enough to have a high degree of certainty as to earnings and cash flow. But as you can see in the chart above, margins for the company have remained fairly stable over the past few years . If we assume that these margins hold for this year, we would get net income of $1.70 billion, adjusted operating cash flow of $1.75 billion, and EBITDA of $2 billion.
Using these figures, we can easily value the company. As you can see in the chart above, the firm is trading at a forward price to earnings multiple of 25. The forward price to adjusted operating cash flow multiple is 24.4. And the EV to EBITDA multiple, aided by $3.33 billion in cash and cash equivalents, and zero debt, comes in at about 19.6. But given how early we are in the current fiscal year, we might want to rely more on the 2022 figures for the company when comparing it to similar firms. In the table below, you can see how the company is priced compared to similar firms. On a price to earnings basis and on a price to operating cash flow basis, compared to the 2022 figures for the company, only two of the five firms are cheaper than our prospect. Meanwhile, using the EV to EBITDA approach, I found that four of the five companies were cheaper than Arista Networks.
Company | Price / Earnings | Price / Operating Cash Flow | EV / EBITDA |
Arista Networks | 31.5 | 30.7 | 24.7 |
Motorola Solutions ( MSI ) | 36.8 | 27.5 | 24.6 |
Ubiquiti ( UI ) | 40.8 | 80.7 | 32.9 |
Juniper Networks ( JNPR ) | 19.1 | 100.3 | 11.6 |
F5, Inc. ( FFIV ) | 24.1 | 15.0 | 13.9 |
Ciena Corporation ( CIEN ) | 36.6 | 73.2 | 17.4 |
What we have here is a situation where, relative to similar firms, Arista Networks may be more or less fairly valued. But some investors would argue that the beauty of growth investing is that you pay a premium today in order to have the company grow into its valuation because of the rapid growth it should achieve. This is a fair point, even though it's not a point that I follow in my own investment approach. But even if we assume that the company is going to continue to grow at an attractive pace, it will take until at least 2025 before the stock is priced at levels that indicates attractive upside. You can see this in the two tables below. And the first one, you can see what happens if revenue grows at a rate of 15% per annum from 2024 through 2027, with margins remaining flat from year to year. And in the table below you can see a slightly more aggressive growth rate of 20% per annum. In either case, the company does look to be more appealing the year after next.
There might be some who argue that growth could be greater than 20% per annum. This is not out of the question. But I do see it as unlikely for a couple of reasons. For starters, management did say that the cloud titans the make up a good chunk of their business should see growth ‘moderate’ this year compared to the triple digit growth experienced in 2022. Second, as companies become larger, growth tends to become more difficult. The $5.52 billion in revenue that the enterprise should generate this year is already quite sizable. And third, the company does have a history of growing at rates even slower than this. In 2019, for instance, revenue was only 12.1% above what it was in 2018. Because of the COVID-19 pandemic, revenue actually dropped 3.9% in 2020. It was only after that time that revenue growth really surged. And with general economic conditions creating uncertainty, it wouldn't be a surprise to see an eventual slowdown in this space as well.
Takeaway
Fundamentally and operationally, Arista Networks is a fantastic company. I have no doubt that the firm will continue to grow and create value for its investors in the long run. I was definitely impressed with the financial results management reported for the first quarter of the 2023 fiscal year, and the outlook for the rest of the year looks promising. But sadly, the company fell victim to the same curse that affects many other growth businesses. Even after outperforming what analysts expected, shares took a beating because of how pricey they are and due to broader economic uncertainty. If the stock were cheaper, I would see this as an attractive long-term buying opportunity. In fact, for those focused on the short run, now might not be a bad time to consider picking up a stake. But as a long-term, value-oriented investor, I believe that the stock is just a bit too lofty to make sense at this moment. As such, I have decided to keep it rated the ‘hold’ I had it rated previously.
For further details see:
Arista Networks Demonstrates The Perils Of Growth Investing