2023-05-02 12:49:40 ET
Summary
- Arista Networks reported impressive Q1 earnings, but concerns about slowing cloud customer spending offset news of the company's AI opportunity.
- The company's expansion into new verticals, such as WAN routing systems, offers significant growth potential.
- We believe Arista's valuation is fair, leading us to be neutral on the stock.
Arista Networks ( ANET ) recently reported strong Q1 earnings, indicating a promising outlook for 2023. While we like the company's focus on artificial intelligence ((AI)) networking and expansion into new verticals, we are concerned about the potential moderation in Cloud Titan spending. Despite these concerns, we believe the stock's valuation is fair, leading us to maintain a neutral stance on ANET. In this article, we'll explore Arista's Q1 results, the impact of AI on the company's future growth, and the implications of cloud spending on its performance.
Q1 Delivered Strong Result
Arista Networks reported impressive Q1 earnings , with revenues reaching $1.35 billion and a non-GAAP earnings per share of $1.43. Services and software support renewals contributed to 13.5% of the revenue, while non-GAAP gross margins stood at 60.3%. The company expects gross margins to improve every quarter throughout this year. International contribution registered at 17.5%, with the Americas dominating at 82.5%. The company's outlook for 2023 remains optimistic, with an anticipated annual growth rate of 26% and revenues of approximately $5.5 billion.
Our analysis suggests that the biggest risk to Arista's performance could be the moderation in Cloud Titan spending. Investors are understandably nervous about the lumpy nature of this segment, which could affect the company's ability to maintain its impressive growth trajectory. However, the company's focus on artificial intelligence networking is expected to provide significant upside support for the stock. AI revenue is expected to contribute later in 2023, with a much larger opportunity in 2024 and 2025. This makes near-term volatility in cloud spending the most impactful factor for Arista's ability to achieve its 25% growth target for 2023.
Arista made several exciting Q1 product announcements, including its vision for linear drive optics for intra and inter data center connectivity at 800 gig and beyond. This development has the potential to transform both Arista and the optical industry at large. In addition, the company is targeting the AI market, which demands specialized AI networks to support data-intensive workloads, such as generative AI inference and large language model training applications. With ongoing trials and production deployments scheduled for this year, Arista's AI networking strategy holds significant promise for future growth.
Furthermore, Arista's entry into the wide area network (WAN) routing system is another notable development. The company is targeting mission-critical enterprises where high volume and encrypted traffic matter in a modern WAN. In collaboration with Equinix (EQIX), Arista is well-positioned to develop and deploy the WAN routing system, expanding its reach into non-cloud segments. The company has already registered a solid number of million-dollar customers, which is a direct result of its momentum in the enterprise and campus throughout the past year.
As part of our analysis, we note several customer wins across various verticals, including international government, education, financial, healthcare, and media sectors. These wins demonstrate Arista's ability to deploy innovative solutions based on a consistent architecture, allowing each customer to modernize their network with the power of its platform.
While the moderation in Cloud Titan spending poses a risk to Arista's performance, the company's focus on AI networking and its expansion into new verticals, such as WAN routing systems, offer significant upside potential in our view. The anticipated contributions from AI revenues later in 2023, and an even larger opportunity in 2024 and 2025, make it crucial for Arista to navigate near-term volatility in cloud spending in order to achieve its ambitious 25% growth target for 2023.
Diving Deeper Into AI
We believe that Arista Networks' AI opportunity presents a significant potential for the company's growth in the coming years. As the AI market continues to expand, Arista is well-positioned to take advantage of this growing sector. In our view, AI will transition from a non-material contributor in the past to a key driving force in Arista's performance this year and beyond.
Arista's edge in the AI market is evident in its focus on high-speed connectivity tailored for AI applications. We believe that the company's capabilities in the 400- and 800-gig segments, driven by AI backfill applications, could be a key differentiator. Backfill applications refer to those that fill the gaps in processing capabilities of the current generation of AI applications, ensuring that resources are utilized efficiently. High-speed connections are essential for handling compute and data-intensive workloads, such as generative AI inference and large language model training applications, which are expected to grow rapidly in the near future.
The company's flagship AI platform, the 7800, showcases Arista's commitment to optimizing "network assurance for mission-critical AI and ML workloads". The platform offers "advanced features like microbursts, Fan In congestion management, ultra-deep packet buffer memory with latency analyzer, and real-time telemetry". It also provides "visibility, automation, and dynamic controls for AI and ML data centers", all based on open standard ethernet. We believe that these capabilities make Arista's AI platform an attractive offering for cloud customers seeking to invest in AI networking infrastructure.
Given the growth in the AI networking market, we think that Arista has the potential to capture a significant market share in the coming years. We project that the AI intensive network TAM will reach $2 to $3 billion in just a few years, highlighting the substantial opportunity for Arista to capitalize on this trend.
Arista's AI strategy appears to resonate with its cloud customers, with the company currently engaged in trials that will culminate in production deployments in 2023. As AI networking becomes increasingly prominent in the coming years and throughout the decade, we expect Arista's market position to potentially grow from strength to strength.
Financials & Valuation
Note: all data comes from FactSet.
Our analysis of ANET's financials reveals a strong performance in the past year, with product revenue surging by $1.3 billion, or 56.3%, in the year ended December 31, 2022, compared to 2021. This increase can be attributed to robust demand for ANET's switching and routing platforms from a diverse customer base, including significant contributions from large cloud customers. Despite improvements in component supply towards the end of 2022, supply chain and manufacturing constraints hindered revenue performance throughout the year.
Moreover, ANET's service revenue saw an uptick of $94.9 million, or 16.6%, during the same period, as the company experienced continued growth in initial and renewal PCS contracts due to the expanding customer installed base. However, it is worth noting that international revenues as a percentage of total revenues dropped from 26.8% in 2021 to 21.0% in 2022. This decline was mainly driven by increased purchases from large cloud customers in the Americas region.
In response to cost inflation in the supply chain, ANET implemented targeted price increases during the year, which started to positively impact revenue in late 2022. As supply chain costs improve, we anticipate that ANET will return to a more competitive pricing environment for its products and services.
ANET's EPS showed an impressive growth of 60% in 2022, and it is expected to grow by 27% in 2023 on the back of a 26% sales growth projection. This continued growth in earnings per share reflects the company's strong financial position and its ability to capitalize on the growing demand for its products and services.
Taking into account ANET's robust financial performance, the stock is currently trading at a premium multiple of 27x forward 12-month consensus EPS. Although this represents a roughly 50% premium compared to the S&P 500, it falls within the mid-range of ANET's 5-year historical valuations. This suggests that, in our view, the stock's valuation can be considered relatively fair, given the company's strong financial position and growth prospects.
Conclusion
Arista Networks has demonstrated its ability to deliver strong financial performance, driven by the growing demand for its innovative solutions across various verticals. We like the company's focus on AI networking and its expansion into new markets, which offer significant growth potential. However, concerns about slowing cloud customer spending and the challenges of navigating near-term volatility in this segment weigh on our outlook for the company.
Despite trading at a premium multiple, we believe Arista's valuation appears relatively fair given its strong financial position and growth prospects. Balancing these factors, we maintain a neutral stance on ANET. Investors should closely monitor Arista Networks as it continues to capitalize on the emerging AI market and navigate the potential moderation in Cloud Titan spending.
For further details see:
Arista Q1 Earnings: Balancing AI Opportunities And Cloud Spending Concerns