Seeking Alpha
Long/short equity, special situations, value
Profile| Send Message|
( followers)  

Summary

  • Arista Networks just finished a hugely successful initial public offering.
  • The company is seeing phenomenal, accelerating and profitable growth.
  • The risks put me off: a high valuation, competition and a lawsuit prevent me from picking up some shares.

Arista Networks (NYSE:ANET) is a supplier of cloud networking solutions which uses software innovations to address the needs of internet companies, cloud service providers and next-generation data centers.

The company witnessed a highly successful public offering last week, despite worries about the premium valuation, competition and lawsuits. I do find the risks serious, which is the prime reason for me to hold off making an investment at the moment.

The Public Offering

Arista Networks solutions are based on the Extensible Operating System, or EOS, a set of network applications, as well as 10/40/100-Gigabit Ethernet switches. The company's core EOS is fully programmable and flexible, addressing the different requirements of users, including reliability, automation, analytics and visibility, among others.

Arista was founded in 2004, and shipped its first products in 2008. Growth has been spectacular in recent years, as the company grew the cumulative end-customer base from 570 in 2010 to 2,340 by the end of 2013.

Arista sold 5.25 million shares for $43 apiece, thereby raising $226 million in gross proceeds. As far as the press release reveals, all shares were offered by the company, with no shares of selling shareholders being offered.

The pricing of the offering has been strong, taking place above the high end of the preliminary offering range of $36 to $42 per share set by the firm and its bankers. At $43 per share, the offering valued Arista at $2.7 billion. Following the successful debut in which shares have risen to current levels at $55 per share, this valuation has risen to $3.5 billion.

The major banks that brought the company public were Morgan Stanley, Citigroup, Bank of America/Merrill Lynch, Barclays, Credit Suisse, Deutsche Bank and RBC Capital Markets, among many others.

Valuation

Arista is focused on its EOS offering, which supports leading virtualization and cloud solutions, including offerings from VMware (NYSE:VMW), Microsoft (NASDAQ:MSFT) System Center and OpenStack, among others. The company has gained many prominent customers in recent years, which include cloud service providers like Facebook (NASDAQ:FB), Microsoft, Yahoo (NASDAQ:YHOO) and large bulge-bracket banks.

Cloud networking has many advantages over legacy networks, including better performance, better availability, programmability and flexibility, and lower costs. The company's EOS solution is set to address the scale needs of customers in the cloud. The company's target market, data centers with switching markets for 10-Gigabit Ethernet or more, is expected to double between 2013 and 2017 to become a $12 billion market. This is according to research firm Crehan Research.

For 2013, Arista generated revenues of $361.2 million, which is up by 86.8% on the year before. The company doubled its net income to $42.5 million.

The company operated with $113.7 million in cash and equivalents before the offering took place. On a pro forma basis, Arista will operate with roughly $44.3 million in debt and $289.1 million in cash, resulting in a $250 million net cash position. Given the strong offering, the net cash position might actually come in above this estimate.

This values operating assets of the business at roughly $3.25 billion, which values Arista at a little over 9 times annual revenues and a little over 75 times GAAP earnings.

Investment Thesis

As noted above, the public offering of Arista Networks has been a huge success. Shares were offered some 10.3% above the midpoint of the offering range, after which they rose by 27.9% on their first trading day.

Valuations are very steep, based on the 2013 results, despite the rapid and profitable growth. Therefore, forward-looking metrics might be more appropriate, with revenues for the first quarter increasing by more than 91% to $117.2 million. Net earnings were up by 86.5% to $12.3 million.

The strong, accelerating and profitable growth are huge pros for this public offering. Extrapolating first-quarter earnings of $12.3 million, Arista should be able to post earnings north of $50 million this year, which still results in a valuation north of 60 times earnings. This obviously does not make it a bargain.

Besides the valuation risks, there are the usual risks for these kinds of offerings. This includes a limited operating history, and large and resource-rich competitors like Cisco Systems (NASDAQ:CSCO) and Juniper Networks (NYSE:JNPR), among others. Furthermore, note that Arista's top 10 customers make up 43% of total revenues, and that this percentage has been on the increase recently.

Perhaps the biggest risk is the lawsuit which the company has seen filed against it by OptumSoft. The latter states that ownership of components of the EOS systems belong to the company, after OptumSoft and Arista worked together in their start-up phase. Following the major disagreement between both companies, David Cheriton, who is one of Arista's founders, resigned in March of this year and is actually suing Arista. He seems very motivated given that his trust holds 22% of Arista shares, making it the largest shareholder in the company.

Despite the great growth, profitability and successful initial public offering, the risks outweigh the opportunities, in my opinion. Notably the high valuation, potential tougher competition and the lawsuit are risks which make me cautious.

I remain on the cautious side, but keep the stock on my radar in case a big post-IPO sell-off might occur in the coming months.

Source: Arista Networks: Successful IPO For This Company, Yet Risks Are There