2023-05-01 12:20:23 ET
Summary
- Arista Networks' cloud-based, high-speed integrated networks have made significant inroads in cloud networking solutions.
- Its focus on cloud and hyperscalers gives it commanding heft and a huge competitive advantage in that user segment.
- Arista should continue to benefit from spending on AI and the need for faster and low latency networks.
- While it had tremendous growth in the last decade, growth in the next is likely to be slower.
- Arista is easily the best in its category, overpriced, but definitely worth buying on declines.
The Networking Stalwart
Arista Networks (ANET) was co-founded 15 years ago by Cisco Network's ( CSCO ) ex-employees, Andy Bechtolsheim, David Cheriton, and Ken Duda, with current CEO, Jayshree Ullal, also from Cisco joining them a few years later.
Their main goal was to pursue a high speed, integrated cloud-based networking solution with both hardware and software. A move away from just routers, switches and networking gear, which characterized this industry as a hardware commodity cyclical, riding entirely on tech buildouts with little discernible product difference. They saw the opportunity in and the need for software-driven high speed, low latency virtual networking systems, which were vendor agnostic and primarily designed for cloud operations. Using software to oversee thousands of server networks instead of engineering personnel resulted in savings of 10 to 40X, proving to be one of the catalysts, which grew the business from 2,200 customers in 2013 to over 9,000 today.
These features also made other modules such as security easy to add onto at scale and without the friction of different vendors operating under a legacy on-prem system. The modular approach meant that the network could be modified with add-ons without tremendous costs. With cybersecurity being such an important part of networking, Arista's flexibility allowed it to grow and have deep relationships with the likes of Check Point Software ( CHKP ) and Palo Alto Networks ( PANW ), to name a few.
Strengths and Competitive Advantages
First Mover Advantage in Hyperscale and Cloud Deployments
Microsoft ( MSFT ) and Meta Platforms ( META ) accounted for a whopping 41% of Arista's revenues in 2022.
Arista Revenue Segment Analysis (Seeking Alpha, The Next Platform, Arista Networks, Fountainhead) Arista Customer Analysis (Seeking Alpha, Arista, The Next Platform, Fountainhead)
Arista works very closely with their Hyperscale customers such as Microsoft and Meta from inception, partnering with them to build out their cloud networks -- investing valuable time, manpower and financial and strategic capital -- more as a partner than a vendor. And that has paid huge dividends with revenues from Microsoft and Meta growing at 33% per year in the last 4 years, giving it a huge moat in the Hyperscaler sector.
Importantly, Microsoft and Meta are customers that will not overpay and likely squeeze every penny out from vendors for such huge outlays, but the operating margin of 31% - 35%, strongly suggests that these were never loss leaders to service a large customer. Clearly, Arista provided tremendous value and made a ton in the bargain. Arista's management, when queried about the massive exposure to just two clients, articulated that it is extremely difficult for any other vendor to do what they do. They believe that this is a moat and plays to their strengths. As such, it did not worry them to have such large exposures to just two customers. In fact, Microsoft has been a more than 10% customer for a decade, and Arista revels in that niche.
Market Leader in High Speed Networking
As seen below, Arista is the market share leader for 100-gig and 400-gig ports, a key metric for the fastest networks. Sales of these products doubled in 2021 from $100 to $200 Mn and then likely further to $400 Mn in 2022, according to their C.E.O.
According to Arista's December 2022 earnings presentation, as shown below, Forrester listed it as a wave leader in Open Programmatic Switches for Business Wide SDN.
Arista Leadership (Arista)
CloudVision Software
Arista's Network Managing Tool is a comprehensive and simple subscription service, unlike other service plans from competitors. My primary sources, which included buyers of networking gear for medium and large sized businesses, indicated that one of the reasons they chose Arista was because of the simplicity of the all encompassing service plan, unlike other competitors' plans, which required a PHD to comprehend what was included. Cloud Vision has grown from 300 customers in 2018 to 2,000 customers in 2022, a CAGR of 60%!
Tech Leadership
In the forward to The Making of Arista, C.E.O. Jayshree Ullal writes:
Great leaders and their companies never rest on their laurels. They constantly question themselves, regardless of past glories. They don't adapt to change; they are the change. They create the inflection points that new start-ups take advantage of and existing companies use to reinvent themselves.
Now, doesn't that sound like a certain CEO of Nvidia ( NVDA )?
Jokes aside, I would think the pedigree of the founders is a serious competitive advantage for Arista. The founders' halo created and cemented a culture of working for the best in the industry, thus enabling engineers to creating best in class products. This is not a quantitative assessment, but an attribute I've constantly been hearing from industry sources, and not all if it is hype - it does show up in margins. Arista's average net profit margins for the past 5 years have been north of 29% --- and these are clean GAAP numbers. You have to be doing something special and charging a hell of a lot for it when your margins are off the charts.
Switching Costs
For large and even medium-sized customers, switching costs (pun unintended) are huge in terms of money and time spent on processes and manpower, which results in a huge advantage for the incumbent.
Opportunities
Arista believes that they have just scratched the surface of a growing market, with a TAM of $51Bn in cloud networking. Andy Jassy, CEO of Amazon commented that 90 to 95% of all IT spending remained on-prem, indicating that cloud spending was still under-penetrated.
Arista Growth Opportunities (Arista)
Arista also sees Data Center and Campus opportunities of $40Bn
Arista Campus Opportunities (Arista)
Meta is not slowing down. With better than expected results, Meta also maintained its capital expenditure forecast of $30B-$33B (still building out AI capacity to support ads, Feed, and Rees, and more investment in generative AI). While it will take a while to digest the massive $1.1Bn purchases in 2022 Arista, growth opportunities will continue for Arista from its largest customer.
Neither is Microsoft , with its emphasis and focus on AI and ChatGPT.
On its March 2023, ended conference call, CEO Satya Nadella said
"The company is not being shy about investing in where we need to invest to grab the opportunity"
Weaknesses and Threats
Cisco should not be ignored : While there are significant product and process differences between Arista and Cisco, this is not the scale of Intel ( INTC ) falling a few generations behind Nvidia and Advanced Micro Devices ( AMD ) in upgrading from a 10nm to a 7nm to a 5nm and 3nm and completely losing out a few generations.
While the market share grab of a much nimbler, cloud-based competitor at the expense of an on-prem legacy, slower incumbent growing at a third of their speed is all too familiar, I would like to point out that Cisco is still 10 times Arista's size and fills a very vast and dispersed non-hyperscaler market, which Arista competes in with several other network competitors. If growth stalls in the cloud and we saw Amazon ( AMZN ) slip with the scare of single digit growth from over 40% a year back - there is not that much of a market left that grows as fast . The growth slowdown will lead to cost cutting, which in turn will lead to price competition -- that is a threat, specially from the 800 pound gorilla that has substantial experience in wading through tight markets. Besides, Arista has made no bones about their preference for the hyperscalers, so it will take a special skill set and strategy to achieve the same success in a different segment.
Secondly, as we saw in the revenue tables, non-Microsoft/Meta growth has been only 13% as compared to 33% for those two. And even though Arista speaks of sizable opportunities in Campus and other segments, the forecasted growth rates are so much slower. The Campus Ethernet market opportunity is really Cisco's battleground, which makes me wonder how far Arista can go in terms of market penetration. Arista cannot easily get two more behemoths but needs to get into a more competitive slower growing market, which is out of their wheelhouse. Surely campuses don't have the kind of resources....and will likely fight tooth and nail on pricing. We may have seen peak margins.
Arista and Cisco (Seeking Alpha, Arista, Cisco, Fountainhead)
As we can see above, Arista beats Cisco on growth and net margins by a mile, but of course, we end up paying almost 9x sales for Arista as compared to 3.4x for Cisco. Interestingly, Arista's PEG is slightly lower at 1.5 compared to 1.6. Arista scores much better on earnings multiples because of the great profit margins.
AI growth - a faster network and low latency are great for growing AI spend, and even though Arista's network is more cloud-based and holistically planned around a cloud-based multi-consumer network than its competitors, Cisco and other competitors could make the same pipes. While Arista's superior process and integration capabilities for large scale rollouts are the clincher, the hardware alone is not a superior product for AI applications.
Large customers skipping upgrades - Two customers accounting for such a large share of the business can be a weakness, should even one skip an upgrade as we saw in 2020 and 2021, when growth dropped 26%, with Meta skipping the 200 Gb/sec Ethernet upgrade and Microsoft taking a smaller bite.
Valuation and Investment Case
Arista Investment Case (Seeking Alpha, Fountainhead, WSJ, )
A hugely profitable company : Arista is a tremendous company and clearly the 31% net profit margins are mouth-watering, and it's not just these last three years with Microsoft and Meta, the prior three years also had a great net profit margin of 26%. Clearly the "land and expand as a partner with the customer", strategy has worked very well for them.
Great Competitive Advantage : Arista's hold with Microsoft and Meta is a huge competitive advantage, which is unlikely to be relinquished in the near future. The capacity to partner and strategize from scratch with a humongous customer and satisfy the myriad problems that come with such large installations is huge.
The Network industry has a long runway : Even though cloud growth has slowed down in 2023, there are huge opportunities, which should ensure sustained though slower growth in the next decade.
The main downer is the price : Arista quotes 9X sales and 29X earnings, that too in a slower year with 16% sales growth in the next three compared to 22% in the past three. On an earnings basis, it gets better. Sure, its P/E is high at 29x but with 19% estimated growth in the next three the PEG drops to 1.5, which is good for a best-in-class, high-margin, high-growth company still less than 20 years old, in a fast growing industry.
I recommend buying Arista on declines . Overall, I expect 2023 to be a tough year and we should get a market correction - $130-$140 should be good entry points.
For further details see:
Arista, The Network Stalwart