2024-01-11 02:53:11 ET
Summary
- Arista Networks has experienced significant stock growth due to the adoption of generative AI in business processes.
- The company is a leader in cloud-based networking technology, taking market share from Cisco.
- Arista's growth is supported by increased investments in AI technologies, improved enterprise IT budgets, and an improved supply chain position.
- The company continues to expect sky-high margins and 20% revenue growth in Q4.
Last year's generative AI boom had large spillover effects across the entire technology industry. Though AI software companies were the most obvious beneficiaries of growing public interest in ChatGPT and related technologies, the fact that many companies have started to look into adopting generative AI to automate business processes has also benefited hardware vendors.
Arista Networks ( ANET ), the leading cloud-based networking hardware vendor, has been on a tear for this reason. Its stock has risen more than 2x over the past year as the company successfully executed double-digit revenue growth while improving supply chain constraints:
Multiple tailwinds powering earnings expansion
Now, as we look ahead to FY24, I continue to see further upside for Arista and am bullish on this stock despite its sharp recent rally. I last wrote a neutral opinion on Arista back in 2022, but my more cautious take back then was during a time of declining margins, supply chain uncertainty, and slower EPS growth rates - challenges that Arista has now more than surmounted and with more powerful growth drivers as well.
For investors who are relatively newer to Arista, here is my long-term bull case for the stock:
- Leader in cloud-based networking technology. Arista has for years been recognized as the best cloud-oriented vendor of networking hardware technology, continually taking market share from original market incumbent Cisco ( CSCO ) as more and more customers, particularly large internet titans like Meta ( META ), have gravitated toward Arista products.
- AI tailwinds. As companies invest in AI technologies, they are building out their datacenters to be able to handle the required data storage and ingestion volumes. Datacenter investments, in turn, require buildouts in networking hardware, which is a tailwind to Arista's growth trajectory.
- Enterprise IT budgets are in better shape. After the first half of 2023 was defined by headcount cost-cutting and a delaying of non-critical projects, the better macroeconomic outlook for 2024 hopefully points to a normalization of enterprise buying patterns, which is excellent news for Arista, which counts on large enterprises for a big chunk of its revenue.
- Improved supply chain position. The company has been able to reduce lead times for customers while gaining cost efficiencies in purchasing components. Improved build lead times also reduce the risk of building an incorrect product mix and producing inventory reserves.
- Rich gross margin profile. Arista sells hardware products, but its financials read more like a software company (after all, the premium pricing of its products is driven by Arista's software features value-add). The company's 60%+ pro forma gross margins give the company excellent scalability on its overall earnings.
Risk factors and valuation
Now, in spite of these strengths, we can't be blind to the risks that stand for this stock. The first is a fundamental risk: Arista relies on a disproportionate amount of revenue contribution from large single customers, such as Meta and Microsoft ( MSFT ), which it refers to as the "cloud titans." Clustering together this demand alongside AI-related purchases, company management is now expecting this group of core customers to contribute to 40% of overall revenue, per CEO Jayshree Ullal's remarks on the recent Q3 earnings call :
During the past year, our cloud titan customers have been planning a different mix of AI networking and classic cloud networking for their compute and storage clusters. Our historic classification of our cloud titan customers has been based on industry definition of customers with or likely to attain greater than 1 million installed compute servers. Looking ahead, we will combine cloud and AI customer spend into one category called cloud and AI titan sector. And as a result of this combination, Oracle OCI becomes a new member of the sector, while Apple shifts to cloud specialty providers. This new cloud and AI titan sector is projected to represent greater than 40% of our total revenue mix due to the favorable AI investments expected in the future."
Buying patterns in this space, meanwhile, are incredibly lumpy as they are subject to the whims of large single customers, and there have been periods of contraction in Arista's recent history that have led to sharply lower growth rates and inventory buildups.
And while Arista's improved supply chain position is an overall positive, the company notes that its reduced customer-facing lead times also means that customers are less incentivized to place longer-term orders: hurting Arista's revenue visibility in the near term. There's a good chance, in other terms, that its current ~30% y/y revenue growth may represent a pull-forward of demand that may leave 2024 more flattened.
The other core risk here is valuation. For FY24, Wall Street analysts are expecting Arista to generate $7.28 of pro forma EPS (+11% y/y) on $6.56 billion of revenue, up 12% y/y (data from Yahoo Finance ). So at current share prices near $249, Arista trades at a 34x P/E ratio.
Still, I think that Arista's superior growth profile must be considered. Rich gross margin expansion plus opex rationalization have led Arista to yield 46% earnings growth in its most recent quarter. And while the pace of this earnings expansion is in question (clearly consensus isn't expecting this to last into FY24), when considering Arista's PEG ratio based on its current EPS growth rates, its PEG of 0.7x signifies opportunity.
It's also worth noting that Arista has $4.5 billion of net cash on its balance sheet unencumbered of debt, which is worth ~6% of its $77.5 billion market cap, so on an "ex-cash" basis, Arista's valuation multiples would also be 6% lower.
Recent trends demonstrate aggressive margin expansion and continued strong growth ahead
Arista's recent financial releases help to justify the momentum behind the stock. First, a snapshot below of the company's aforementioned margin expansion:
Gross margins rose 190bps y/y to 63.1%, which the company attributed to higher enterprise shipments plus improved supply chain costs, a benefit from the company's ongoing supply chain normalization after exiting a very constrained pandemic supply environment. The company doubled down on this gross margin gain in achieving a 430bps y/y expansion in pro forma operating margins to 46.1%, among the highest in the industry. The operating margin gains on top of gross margin gains were driven by lower new product introduction costs, lower product demo costs, and operating leverage on both sales and marketing as well as general and administrative costs.
Furthermore, Arista expects good times ahead at least through Q4, where the company's $1.50-$1.55 billion revenue outlook represents 20% y/y top-line growth (versus 29% y/y growth in Q3), as well as sustaining 63% gross margins from Q3:
Key takeaways
With aggressive earnings expansion, multiple tailwinds for continued growth including enterprise AI adoption, and its leading market position, there's a lot to like about Arista heading into 2024. Keep riding the upward wave here.
For further details see:
Arista Networks: Incredible Execution And AI Tailwinds Justify High Price (Rating Upgrade)