2023-03-24 08:30:00 ET
Summary
- Arista Networks demonstrated impressive top-line growth in FY'22, which snowballed into its growing EPS surpassing the performance of its industry peers.
- ANET's diverse product portfolio positions it favorably to meet the needs of both enterprise and hyperscale cloud customers, allowing it to capitalize on the expanding Total Addressable Market (TAM).
- However, ANET is currently facing some short-term risks, such as a slowing gross margin outlook and a declining R&D expense ratio.
- Nonetheless, ANET remains fundamentally liquid, making the stock attractive, especially during its pullbacks.
Arista Networks ( ANET ) is a leading provider of innovative, software-driven networking solutions that have helped it stand out from legacy competitors and consistently gain market share. The company's strong performance in FY'22, with impressive top-line growth and a growing customer base globally, demonstrates its ability to adapt to changing market conditions. The management remains confident in the health of its key product portfolio, which demonstrates their commitment to meeting the evolving needs of enterprise and hyperscale cloud customers.
While concerns exist about slowing research and development expense ratios, ANET has a track record of pushing the boundaries of traditional networking and delivering cutting-edge solutions to customers. The company is well positioned for future growth with an expanding Total Addressable Market ((TAM)), making the stock attractive, especially during its pullbacks.
Company Overview
Arista Networks is known for pushing the limits of traditional networking by using software-driven solutions to make networking solutions that are faster and more efficient. Their solutions have gained recognition in the industry with numerous awards . Additionally, it has been able to differentiate itself from legacy competitors in the networking industry by focusing on software-driven solutions.
ANET has a diverse product portfolio focused on cloud and data center products, network adjacencies, and network software and services. The company's flagship product, Arista EOS Network, is a software-based solution that provides programmability at all levels of the network stack, making it easier for users to manage network traffic flows, automate network operations, and improve reliability.
Additionally, the company's offerings involve combining security and observability into a single, unified solution. Arista's CloudVision platform allows organizations not only to monitor network traffic and detect potential threats but also to take immediate action to mitigate those threats. All of this is embedded in their Client-to-Cloud Portfolio. Thanks to these innovative solutions, the company has been able to take a significant market share over its peer Cisco (NASDAQ: CSCO ), as shown in the image below.
ANET: Consistent Market Share Gains vs Cisco (Source: Q4 2022 Earnings Call Presentation)
This has established Arista as one of the global leaders in providing organizations with the tools to upgrade their cloud networking solutions, thereby positioning them favorably in today's digital transformation.
ANET is truly excelling in its industry, thanks to their exceptional technological solutions. They have established a strong foothold in the market, boasting a customer base of over 9,000 across the globe with an impressive net promoter score of 80.
Management remains confident that their key product portfolio remains healthy. In fact, cloud and data center products, which are built on an Arista EOS stack, contributed 68% of ANET’s total revenue and doubled its 400-gig customer, as quoted below.
This drove approximately 68% of our revenue with strong cloud and enterprise spending cycles. We believe that we will continue to gain market share in the high-performance switching and have already grown from the teens to the 20s. In the 100 and 400-gig category, we have now earned the number one position according to industry analysts. We have also doubled our 400-gig customers from 300 in 2021 to over 600 in 2022.
-Source: Q4 2022 Earnings Call Transcript
Upgraded Product Series
ANET's management has made an impressive move by upgrading their 7050X4 and 7060X5 product series. These advanced solutions have been designed to meet the needs of both enterprise and hyperscale cloud customers, enabling them to achieve unprecedented network speeds while simultaneously reducing their operational and capital expenses.
ANET's 7060X5 800G system is a compelling game-changer in the data center industry. With the capability to provide hyperscalers with the necessary firepower to handle the increasing demands of AI, ML, SaaS applications, and hybrid work environments, these catalysts are poised to unlock significant growth opportunities for the company.
Trading Attractively at $51B TAM
ANET: Growing TAM (Source: Q4 2022 Earnings Call Presentation)
In my opinion, ANET possesses significant potential for growth, thanks to its capacity and expertise to capitalize on the expanding total addressable market ((TAM)) depicted in the above image.
ANET: Resilient and Achieving Strong Growth Performance in FY'22
Contrary to the expected market slowdown, which was expected to affect ANET’s overall demand, the company's growth in product revenue ($3,716.1 million, up 56.3% YoY) and service revenue ($665.2 million, up 16.6% YoY) in FY'22, as well as the increase in total revenue of $4,381.3 million, up 48.62% from the $2,948 million recorded last year, indicate otherwise. Overall, ANET's impressive top line growth in FY'22 demonstrates the company's resilience and ability to adapt to changing market conditions.
ANET: Growing EPS (Source: Q4 2022 Earnings Call Presentation)
Furthermore, as displayed in the image above, it is evident that their earnings per share have been consistently growing. Notably, over the past five years, the company has achieved a CAGR of 26.7%, which surpasses the performance of its industry peers . This impressive growth highlights the company's fundamental attractiveness and potential for continued success in the future.
Assessing Price Action after Its Successful Breakout
As mentioned earlier, Arista is undoubtedly a market share taker. In fact, its price has increased by over 50% from this year's low. When looking at its simple moving averages, it has been printing nicely in a bullish manner, as shown in the chart above. However, in my opinion, today's bullish move has already extended, as evidenced by the huge price imbalance from its 200-day simple moving average, suggesting a correction at today's level.
If there will be a pullback, the immediate significant support will be around $149, which was its previous significant resistance. Considering today's bearish macro environment, I believe waiting for a pullback can be a good investment opportunity. Nonetheless, ANET remains attractive as of this writing.
Still growing, but
ANET possesses a significant competitive advantage, which justifies pricing the company at higher multiples compared to its peers. Nevertheless, there are short-term risks that may trigger a price correction, such as the management's projected slowing margin outlook. Specifically, in Q1'23, management forecasts a slowdown in Non-GAAP gross margin to around 60%, a decline from the 63.9% reported in the same quarter the previous year. This projection raises concerns about the company's future profitability. In fact, analysts are predicting an increase in the forward EV/Gross Profit ratio to 14.4x, which is higher than the company's trailing EV/Gross Profit ratio of 12.6x. Although the expanding operating margin to 40% in Q1'23, up from 38.3%, is reassuring, the inefficiency in the gross margin outlook is a risk that should be monitored.
While the company's forward EV/EBITDA ratio of 20.48x may seem relatively undervalued compared to its 5-year average of 25.60x, it's important to note that this still leaves little margin of safety. As a result, the stock may be susceptible to short-term volatility.
Additionally, Slowing R&D Expense Ratio Poses Threat to Innovation and Market Share
ANET: Improving Operating Margins (Source: Q4 2022 Earnings Call Presentation)
Arista ended FY'22 with a Non-GAAP gross margin of 61.9%, its lowest figure as shown in the image above. According to the management, this decline is mainly due to increased cost related to its cloud titan concentration. Additionally, the company has a growing customer concentration risk, with just two customers contributing 26% of its total revenue.
Management remains confident that this figure is healthy. However, in my opinion, looking at its peer CSCO's recent Non-GAAP gross margin of 63.9% gives a different perspective than “healthy”. Additionally, despite the slowing gross margin, surprisingly its operating margin keeps improving to 41.0%. Upon further investigation, this is at the expense of slowing its research and development expense ratio relative to its total revenue.
ANET: Improving R&D expenses As a % of Total Revenue (Source: Data from SeekingAlpha. Prepared by the Author)
If this trend continues, it could lead to a slower release of new innovative products and ultimately a potential loss of market share. Hence, this could potentially be an early sign of complacency, which could adversely affect ANET’s overall profitability. This increases the risk of today’s market slowdown, which could potentially worsen due to the anticipated decrease in demand for cloud and data center services .
Final Key Takeaway
ANET is currently in good financial standing, with no long-term debt and good liquidity. However, its longer cash conversion cycle, as shown in the image below, may have a negative impact on its gross margin in the future.
ANET: Higher Cash Conversion Cycle (Source: Q4 2022 Earnings Call Presentation)
Overall, Arista Networks remains strong with its growing customer base and expanding total addressable market, making the stock an attractive option, especially given the potential for a pullback.
Thank you for reading and good luck!
For further details see:
Arista Networks: Unlocking Unparalleled Growth Drivers