2023-10-24 05:35:32 ET
Summary
- Arista Networks is a high growth company with massive tailwinds at its back.
- The company's market share is growing, alongside an expanding secular market trend for networking infrastructure.
- Margins have been strong on the back of consistent execution.
- That said, the company is fully valued at more than 10x sales and 30x earnings.
- Waiting for a dip to enter is the best way to play ANET stock - be sure to add this one to your shopping list.
A little more than a month ago, we wrote an article titled " Super Micro: You Should Buy The AI Hype " about Super Micro Computer ( SMCI ), the high-performance compute server company.
In that article, we argued that SMCI was a great buy due to its product line (which is very much in the right place at the right time), its business partnerships, and its relatively attractive valuation.
Today, we're taking a look at Arista Networks ( ANET ), a cousin of SMCI. While both companies sell different products and have different levels of AI impact on their top and bottom-line growth, under the hood, they have a lot in common, including their peer group, their high growth rates, and their strong profitability profiles.
While ANET looks fully valued at the present multiple, we believe that this stock should remain firmly in your shopping cart on any significant price dip.
When there's a gold rush, you should be selling picks and shovels.
Let's dive in.
The Underlying Business
ANET is a strong company from a financial standpoint.
Earnings over the last few quarters have been consistent, as the company has beaten both top and bottom lines consistently over the last few years, something we expect to continue when ANET reports earnings on October 30th next week:
Some may argue that this has been a game played by company management with the analysts, but what is certain is that ANET has grown consistently alongside these beats.
Over the last decade, ANET has averaged 38.7% annual revenue growth, growing top line revenue from $361 million to $5.62 billion between 2013 and the TTM period. EPS has also grown from 0.19 cents in 2013 to $5.57 over the same length of time - absolutely astonishing growth.
As a result, investors have been richly rewarded with gains of nearly 1,250% over that time as results have improved and the sales multiple has grown:
But what is driving this growth?
In short, broad internet usage and digitization trends. As the company explains , ANET is in the business of internet infrastructure. Specifically, networking:
Arista Networks is an industry leader in data-driven, cognitive cloud networking for next-generation data center and campus workspace environments.
At the core of Arista's platform is our EOS software, combined with a set of network applications and our Ethernet switching and routing products using merchant silicon, delivering a cloud networking solution with high performance scale and availability, and enabling network automation, visibility, and security.
This flexible EOS-based platform provides customers with improved price/performance and accelerated time to market.
In other words, ANET turns commodity silicon products (using their proprietary software / hardware solutions) into the infrastructure that runs a majority of the backbone of the internet, both in third data centers and in 'Campus', (on premises) situations.
To be clear, ANET doesn't sell the 'compute' that 'powers' the internet, they just sell the systems that those compute resources use to talk to one another.
ANET's customer list is basically a who's who of major tech companies in the world's two superpower countries, including Amazon ( AMZN ), Apple ( AAPL ), Meta ( META ), Google ( GOOGL ) and Microsoft ( MSFT ) in the United States, and Alibaba ( BABA ), Baidu ( BIDU ) and Tencent ( TCEHY ) in China.
As more and more people get online, and as those people begin to do more online, the demand for continued infrastructure has been, is, and will continue to be immense:
In this way, ANET should be viewed as a 'picks and shovels' play on the growth of the internet itself.
But isn't this a saturated market? Surely ANET can't be the only one selling solutions like this.
True - it is. But here's the thing. ANET is taking share from bigger, more established players like Cisco ( CSCO ):
That way, the company gets to benefit from two growth vectors, not just one - ANET is in a secular growth market, at the same time as it is taking share from larger players within that market.
We expect that this double-tailwind effect should continue to drive results for some time to come.
How Much Are You Paying?
But what about the valuation?
In short, we believe that the company is fully valued.
Seeking Alpha's Quant rating system has the stock at a 'D+', which we think is about right:
It's true that the underlying business is great, but the rest of the market has realized this as well, and the stock is trading at a rich premium.
This isn't ameliorated by looking at historical valuations either.
Looking over the last 5 years, both the top line and bottom line multiple are trading within the standard deviation bands of the linear regression range, at ~11x and 62x, respectively.
That is expensive historically, and nominally, when compared with the average S&P 500 stock.
The only saving grace here is ANET's peer group of other fast growing, highly profitable tech companies - names like Fortinet ( FTNT ), Monolithic Power ( MPWR ), and Paycom ( PAYC ).
Within that cohort, the multiple makes a little more sense, as they all seem to be trading at a more premium valuation on most metrics:
This is all to say that while we like ANET a lot when it comes to the underlying business, the price at the present moment just doesn't make that much sense as a new entrant.
As is often overlooked, the price you pay when you buy into a position really matters, as it can seriously affect a position's long-term appreciation potential.
That said, if you're already holding, then it makes sense to continue doing so.
We like the idea of picking up shares on a dip. While expect that the company will beat earnings next week, if the stock dips considerably on a poor market reaction, it might be a better spot to begin looking for an entry.
How This Goes Wrong
There are a few risks to keep in mind with ANET.
The first has to do with customer concentration, particularly around Microsoft and Meta, at ~40% of revenues. Some would argue that this is a benefit, not a risk, given the size and spend of those two companies.
However, all it takes is one purchasing manager or some committee at one of these tech giants to be swayed to switch to a competing product. This presents a risk, and the loss of either customer would likely spell disaster for ANET's stock price. Given the tailwinds, we don't think this is likely, but there is headline risk here.
The second risk is management's discussion of a 'digestion' year - as first pointed out by Michael Wiggins De Oliveira in his recent article .
This 'digestion' comes on the heels of an extremely robust buildout over the last few years as the general population was forced inside and online. With this burst of spending coming to a close, it's possible that earnings could shrink as demand right sizes back to secular norms. This could hurt the stock price / multiple in the long term.
That said, we see this as a bump, not a meaningfully lower-for-longer situation, mostly due to the tailwinds previously discussed.
Finally, if the market switches away from a combined hardware/software product mix for some reason, then that could hurt ANET's offer considerably.
Thankfully, we don't see that happening.
Summary
All in all, we think ANET is set up for long term success, based on the company's winning product suite, market position, and operational execution.
Waiting to enter the stock until a significant dip seems like the most prudent thing to do, and we're happy waiting to do that - there's no rush when it comes to investing.
That said, be sure to add it to your shopping list for when things turn south.
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Cheers!
For further details see:
Arista Networks: Picks And Shovels For The Internet Itself