2023-11-28 14:55:19 ET
Summary
- Arista Networks' impressive 3Q23 results drove a rise in share price, but lack of margin of safety prompts a downgrade to hold rating.
- Robust business growth with revenue up 28.3% YoY and 3Q23 gross margin at 63%.
- ANET's focus on Ethernet networking for AI clusters and introduction of security solutions positions them well for future growth.
I recommended a buy rating for Arista Networks, Inc. ( ANET ) when I wrote about it the last time due to its impressive 2Q23 results driven by strong revenue, gross, and operating margins. Since the last post, its share price of $184 has risen to $218, which is near my target price. For this post, due to the lack of margin of safety in its share price, I am revising my rating to a hold despite acknowledging that it is indeed a high-quality stock that consistently reports impressive figures.
Review
ANET has shown robust business growth for 3Q23 . Its revenue has grown by 28.3% year-on-year and by 3.5% quarter-on-quarter. One key reason that supports its high revenue growth is due to its consistently strong momentum in the enterprise and AI segments. Its 3Q23's gross margin (non-GAAP) reported was 63%, relatively higher than 2Q23's gross margin of 61.3% and 3Q22's 61.2%. The improvement in gross margin was driven by an enhancement in supply chain overheads. There is a steady decline in SG&A and R&D expenses, thus boosting its operating margin and bottom line. This is evident in the increase in its diluted EPS. 3Q23 diluted EPS increased by 46.4%, reaching $1.83, a significant increase from 3Q22's $1.25 diluted EPS.
Ethernet networking for backend AI clusters is estimated to generate no less than $750 million in revenue for ANET in 2024. This includes devices like the 800G switches, as well as platforms like the 7800 and 7060 switches. The generative AI networking infrastructure roadmap was reaffirmed by ANET with 2023 as the planning year. Trials have been going well so far, and the aim is to have pilots in 2024. In 2025, there will be major cluster deployments, and ANET anticipates income to scale up swiftly after that. While NVLink and InfiniBand are now among the most popular options, Ethernet interconnect at both the front and back ends of an AI cluster will be the default at scale. According to ANET, there are a number of reasons why Ethernet is the best connection technology for AI. Firstly, it is easily monitorable, debuggable, and managed by operators as it has a long history. Secondly, an advantage over InfiniBand is its scalability. ANET, together with other members of the Ultra Ethernet Alliance such as Advanced Micro Devices, Inc. (AMD), Intel Corporation (INTC), Microsoft Corporation (MSFT), Meta Platforms, Inc. (META), and others, is working to develop a brand-new transport protocol that can handle the unique challenges posed by AI workloads, such as load balancing, out-of-order packet delivery, and multi-path delivery. In addition, note that ANET's goal of at least $750 million is predicated on the conventional Ethernet protocol, with the advantages of Ultra Ethernet deliveries serving as an upside to this target. In the current AI-driven world, Ethernet has become the go-to choice thanks to the benefits mentioned above. With the venture into a brand-new transport protocol with other members of Ultra Ethernet, I believe Ethernet's time has not yet come but is just about to begin. Once introduced, it is set to create a major leap in networking for backend AI clusters. Hence, this initiative really positions ANET well for the potential future growth in AI cluster networking.
ANET reaffirmed its projection to generate $750 million in revenue for the campus segment by 2025, up from less than $400 million in 2022. At its very foundation, ANET's unique solution for enterprises is the Extensible Operating System [EOS] stack and CloudVision. With these, enterprise clients can manage their entire infrastructure, such as data centers and clouds, through one integrated framework and management system. ANET has unveiled new security solutions, such as zero-trust networking, to help clients decrease attack surfaces and mitigate the consequences of breaches. By 2027, ANET estimates that zero-trust networking will add $5 billion to TAM. As such, there is a lot of market potential and room for growth in this industry. Thus, I believe ANET's introduction of security solutions into its existing products will give them the opportunity to seize this growing market.
Valuation
I believe ANET can grow revenue to 34% in 2023 and 14% in 2024. For 2023, this is based on management's 4Q23 financial outlook, where they guided revenue of $1.5 to $1.55 billion. With this and the previous three quarters' revenue, I can back out to 2023 total revenue. In addition, this growth rate is also in line with market consensus. For 2024, it is also in line with market consensus. This double-digit growth rate outlook can be attributed to ANET's strong 3Q23 results, where revenue grew by 28.3%. On top of that, its gross margin also expanded by 1.7%, driven by good supply chain overhead management. With Ethernet most likely being the default option for AI clusters that operate on a larger scale, I believe this will give ANET a competitive edge as its networks mainly offer a range of Ethernet switches. Lastly, ANET's unique solution that incorporates new security solutions is set to give them a boost to their campus segment, which drives my growth outlook. My belief is further bolstered by management's own optimistic projection, as I believe it shows their confidence.
ANET is currently trading at ~30x forward P/E. Its peers are trading at a median of ~13x. When I compare ANET's performance against peers, it shows the reason why it is trading at a higher forward P/E. Firstly, ANET's EBITDA margin of ~36% is higher than its peers' median of ~23%. Secondly, the ~27% net margin is also higher than the peers' median of ~17%. In terms of the 1-year expected growth outlook, ANET is expected to grow 34%, while peers' is negative 2%. In my opinion, this disparity in growth outlook is the key reason why ANET deserves to trade higher. However, it seems like my target price is already at its current level. With a lack of margin of safety in its share price, I am revising to a hold rating.
Risk and final thoughts
ANET is already in the process of creating a new transport protocol that can meet the particular difficulties presented by AI workloads, in collaboration with other Ultra Ethernet Alliance members. Since these corporations are large companies with a large market cap, they have the resources to really develop a new protocol that could be considered a technological leap. In addition, they have the money and resources to really push development. If this new transport protocol were to be released sooner than anticipated, it could really change the market dynamics and positively influence ANET's outlook.
For 3Q23, ANET has proven to me that its business growth remains very strong, as its revenue grew at a double-digit rate and its gross margin has expanded. Its gross margin improvements were due to enhanced supply chain efficiency, which contributed to its bottom line. In addition, it is currently focusing on Ethernet networking for AI clusters. It is in collaboration with other members of the Ultra Ethernet Alliance for the development of new transport protocols. This new focus is expected to position them well for future growth. Its commitment to zero-trust networking solutions also presents them with a promising market opportunity that has room for more growth. Thus, I believe this new commitment aligns well with its growth outlook. Since my last post, ANET's share price has indeed improved, and currently, it is trading near my target price. Due to the lack of margin of safety, I am revising my previous buy rating to a hold for now.
For further details see:
Arista Networks: Rating Downgrade Due To Low Upside Potential