Arista: With Growth Slowing Down, Risk/Reward Is Balanced

Summary

• Shares of Arista dipped after reporting Q1 results, primarily on the company's announcement that revenue deceleration would steepen into Q2.
• Following a -12% y/y contraction in Q1 revenues, Arista is calling for revenue to slip as low as -15% y/y in Q2, with operating margins to decline sequentially as well.
• Arista is also no longer producing substantial margin/earnings growth, making its ~25x P/E ratio look quite rich.
• Downgrading to neutral based on Arista's slowing prospects and limited demand visibility in 2020.

The past year hasn't been easy for Arista Networks (NYSE:ANET). As a relatively new entrant in the networking hardware space, Arista was previously able to enjoy huge revenue and earnings growth rates as the company continued to steal market share away from incumbent leader Cisco (CSCO), but now as Arista scales into a company with ~$2 billion in annual run-rate revenues, that explosive growth has pacified somewhat. Add in the uncertainties of the coronavirus, which has led many companies to delay their capex and IT spending plans, and Arista's stock is left looking for direction.

It's important to note, however, that Arista's shares have outperformed the broader market in 2020 - perhaps reflecting investors' optimism that greater usage of the internet and cloud services during the remote-work trend may drive some increase in hardware spend from large cloud titans (while Arista has confirmed this hypothesis is true, there are negative offsets). Whereas major equity indices are still down in the low-teens year-to-date, Arista shares have actually risen in the single digits. That trend of outperformance may slip, however, as following the release of Arista's first-quarter earnings, shares of Arista declined modestly:

Data by YCharts

I was pro-Arista in 2019 and even early this year as the company's valuation multiple - trading consistently in the mid-20s - was below its historical multiples and seemingly undervalued a company that was previously able to produce >40% EPS growth. As I've seen Arista's growth rates taper off and come under pressure during the coronavirus, however, I no longer believe Arista is a deep bargain stock.

At present levels, and considering Arista's rather dour expectations on its performance this year, Arista's risk/reward profile is balanced. While Arista's rich profit margins and ample cash balances keep me from being overly bearish on Arista (because investors will continue to see Arista as a relatively safe stock in the tech sector), I don't see any meaningful near-term catalysts that can significantly lift shares higher. My stance on this stock is now neutral - investors should wait and see until either fundamental performance improves or valuations come down.

Q1 download: longer sales cycles and some supply chain disruptions cast a cloud on Arista's performance

Let's now examine Arista's latest results in greater detail. The earnings summary is shown below:

Figure 1. Arista 1Q20 resultsSource: Arista 1Q20 earnings release

Revenues declined -12% y/y to $523.0 million, slightly beating Wall Street's projection of $517.5 million (-13% y/y), but coming in at the low end of Arista's guided range of $522-$532 million, or -12% y/y to -13% y/y. Worse yet, this is Arista's second consecutive quarter of year-over-year revenue decline (and the only two quarters of revenue decline in the company's history), with growth decelerating five points from last quarter's -7% y/y growth rate. Product revenues in Q1, meanwhile, slipped an even steeper -19% y/y, eight points weaker than -11% y/y in Q4.

Unlike the many other tech stocks that have seen stable share prices this year, the majority of Arista's revenue base is non-recurring, and each sale it makes must be renewed. To some extent, we already expected some weakness in Q1 revenues as Arista cited tough comps versus the first half of 2019 due to revenue recognition timing - but we had hoped that Arista would be able to maintain single-digit decline rates, and that the worst would subside by Q2. This doesn't seem to be the case any more - Arista's guidance for Q2, calling for $520-$540 million in revenue (-11% y/y to -15% y/y), has growth decelerating even further at the midpoint. Wall Street, meanwhile, had hoped for $544.2 million in revenue, or growth improving to -10% y/y.

Figure 2. Arista guidance updateSource: Arista 1Q20 earnings release

In terms of how the coronavirus has impacted Arista's business: while investors' earlier hunch that cloud titans would boost their hardware spend in the near term to support increased usage is true, Arista believes that this short-term boost is fully offset by other customers prolonging their purchasing cycles. CEO Jayshree Ullal noted that the company's revenue visibility for 2020 is quite low (which may also mean Arista is at risk of meeting Q1 guidance) in her prepared remarks on the Q1 earnings call:

Our visibility, especially into second half 2020 is pretty low. The number of confirmed COVID-19 cases has increased sharply in April. Until, the economic environment permits us to resume more normal routine, we have limited visibility to demand.

It is clear that we live in uncertain times, and therefore, with what we know at this time, it is prudent to assume our annual 2020 revenue may decline versus our 2019. We expect to manage our overall business this year at Arista's 2018 levels, and we'll continue to monitor this closely.

Arista, together with the entire business sector and global supply chain is scoping with multiple unknowns in the midst of a global pandemic. We expect to see some short-term strength in cloud titan, offset by prolonged sales cycles with new prospects in the campus and enterprise sector."

Another potentially concerning update is that Arista noted some supply chain shortages for some products in its lineup. Arista is working to resolve these component shortages, in the meantime Ullal has warned that lead times "have doubled recently for our popular products.

Additionally disappointing is the fact that Arista's margin profile softened slightly in Q2. Though Arista managed a 110bps boost in gross margins thanks to a higher mix of service to product revenues in the quarter, it squandered these gains through higher operating expenses. Despite the decline in revenue, sales and marketing expenses rose 12% y/y in the quarter to $57.2 million, while general and administrative expenses also ballooned 18% y/y to $18.3 million. As a result, Arista's operating margins fell 40bps to 37.1% - rare for a company that has a long history of margin expansion and double-digit percentage gains in EPS.

Figure 3. Arista margin trendsSource: Arista 1Q20 earnings release

Arista also further expects pro forma operating margins to slip to the ~35% range in Q2, presenting another red flag. Though many companies in the tech sector have announced spending cuts (through furloughs, layoffs, exec compensation cuts, and cutbacks in advertising spend) to preserve profitability throughout the coronavirus, Arista has not yet announced a plan to eliminate expenses this year.

Perhaps why deep spending cuts are unnecessary, however, is the fact that Arista still maintains a fortress balance sheet - which is one of the primary reasons it's difficult to be overly bearish on this stock. Arista still generated $194.5 million in operating cash flows this quarter (+15% y/y), adding to a substantial cash pile that ended Q1 with $2.64 billion in cash and investments, versus no debt. For sizing purposes, Arista's operating expenses in Q1, after netting out stock compensation, depreciation/amortization and other noncash charges, amounted to only $146.6 million. This suggests that Arista has substantial resources to withstand a sharp downturn in sales for an extended period of time.

Key takeaways

With this much liquidity on hand, investors will likely continue to view Arista as a safe, dependable stock that still generates operating margins in the high 30s. Still, Arista's consecutive declines in revenue to the mid-teens, the reductions in the company's operating margins, and the fact that pro forma EPS slid -13% y/y in Q2 (versus EPS gains of nearly 40% in early FY19) make us question Arista's premium valuation multiple.

A stock trading at a 25x forward P/E ratio like Arista comes with an implied promise of above-market growth - but with both Arista's revenue and EPS declining in the low teens, we fear Arista's valuation multiple may begin to recede from its past premiums. I'd be interested in Arista again if it slid below a 20x P/E multiple versus consensus FY21 EPS of $9.72, which is roughly flat to Arista's earnings in FY19 (a $195 price target), but I see no outsized benefits to buying Arista at present values.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.