Arista Networks (NYSE:ANET) is a seller of IP and ethernet-based networking products. On the back of slowing growth, a significant customer (Microsoft (MSFT)) cutting capex spending, and COVID-19 concerns, Arista has been trading down 30-50% off the 52-week highs. I believe this $200-220 price range that Arista Networks is currently trading in to be a good entry point for investors looking to buy-and-hold over the next few years.
An Overview of Arista Networks and Customers
Image: Arista Networks Logo
Arista Networks, as I mentioned, sells IP and ethernet-based networking products to a variety of companies. If a firm requires a network buildout of any kind or deals with any sort of communications, then that firm operates in Arista's total addressable market.
Some practical uses include streaming TV providers, trading firms (low-latency for high-frequency trading), healthcare, banking, insurance, or the infrastructure that powers the "cloud titans."
"Cloud titans," includes the likes of Microsoft (MSFT) and Facebook (FB), two of Arista's largest customers. While I hate to spoil my "risks" section so early on, it should be noted that Microsoft and Facebook make up 23% and 16.6% of sales respectively (per 10-K).
In total, Arista boasts more than 5,000 customers, primarily in the United States. These customers turn to Arista thanks to its advancements in networking hardware, the ease of working with Arista, the support Arista provides, and the list of technology partners that have software that can readily tie into a buyer's Arista Networks built ecosystem.
Competition Is Strong
Arista Networks is a $16B firm competing against one of the biggest names in tech, Cisco (CSCO). This is not an article about Cisco, but I am bullish on its prospects in much the same way as I am of Arista.
Other names readers might be familiar with include Juniper Networks (JNPR) and Huawei. Juniper presents healthy competition against Arista on many fronts. Huawei, at least in the United States, not so much given the current macro landscape.
Image: Arista Networks support map (each pin is a location, red are closed)
While Juniper, Cisco, and Huawei all compete to supply the buildout of networks around the globe, there is one distinctive feature of Arista that I feel makes them stand out over time, their customer support.
In a recent talk (video above), Arista COO Anshul Sadanda discussed the company's goal of providing a fantastic operator experience. In the video, Sadanda notes that 18 seconds was the average time for a person calling the toll-free number to be connected to a real-life human ready to answer questions, not a machine. Oh, and that human, they're not just looking to hand you off; they're third-level support and trained to get problems resolved.
Alongside strong support, Arista also has big tech on its side. Facebook, to not become single-sourced and own everything internal, worked with Arista to ensure that their own "FB Minipack" was interchangeable with Arista's latest 7368 switches. This shows an innate ability of Arista to go where for-profit companies traditionally wouldn't, into the white-box world (open source).
Work From Home / Stay At Home Are Here To Stay
I used to say we will "return to normal," but the longer the lockdowns go on, the more apparent it becomes that "normal" is gone. During Microsoft's earnings call, Satya Nadella said something that changed my opinion of our future:
As COVID-19 impacts every aspect of our work and life, we have seen two years' worth of digital transformation in two months.
Our digital transformation may recede a little once COVID-19 is marked "resolved," but people will be choosing to stay home a lot more. Let's face it, we were already heading that way, COVID-19 just accelerated it. Conferences seeing success online might remain online. We'll likely see businesses keep some form of remote around. Consumers will opt for the latest streaming release over an overpriced cinema trip. All of these, and more, will require network infrastructure to be updated and made faster than ever, leaving Arista Networks in a prime position going forward.
Data centers that were using 100G switches will need to upgrade to 400G, if they haven't already, and very few companies make a reliable 400G switch. Arista is also working on 800Gb ethernet and switches that will support it (ETA 2023), which would be genuinely game-changing and push us ever closer to terabit Ethernet connections. You'll have to excuse my use of a Cisco image, but the following shows why we already needed faster connections (and this has now been accelerated).
Image: Data usage 2015-2020 in zettabytes per year
One Of The Best Balance Sheets In The Sector
Now for the business side of things. As I mentioned, I am bullish on the whole industry. I like Cisco, Juniper, and Arista Networks, and I believe they all have a fantastic future ahead of them. When it comes down to it, though, the balance sheet is what has me raving about Arista Networks.
Chart: Arista Networks cash & equivalents quarterly
We will start with cash on hand where Arista has managed to build up a fairly sizable position. At more than 15% of the firm's market capitalization, one could argue that Arista is a prime takeover target in the space. This is made even more likely when factoring in Arista's zero long-term debt.
One way to visualize the excellent financial position Arista finds itself in is via a crude mathematical exercise. If we assume Arista lost all sales but did not cut operating expenses, how long could the firm survive? The answer is a little over a year and a half.
We are being unfair, however. Arista would continue to make a product and have inventories. Even still, the company could survive a downturn that saw no one purchase for a full year, at a minimum. That's the kind of stability we should be looking for when uncertainty greets us at every corner.
Making it better for investors, Arista won't see zero sales. As we discussed in the last section, they're a competitor in what is sure to be a surging industry over the next couple of years. The company will get a second wind, too, with 800Gb ethernet in 2023.
There Are Risks
The most significant risk facing Arista Networks has already been discussed a little in this article, an over-reliance on two customers. Microsoft provides some 23% of revenues, and Facebook another approximately 17%. 40% of business being reliant upon two companies is a risk all investors should be wary of.
Chart: ANET Price over the last year
A loss of one of those two companies would be a considerable burden to growth for Arista, and we've already seen that play out on a somewhat smaller scale over the last year. With Microsoft's reduction in capex spending, Arista took several deep steps down in trading prices, as you can see in the graph above.
While it has not been confirmed that spending increases will resume at Microsoft, I'd have to imagine it would given the two-years of digital transformation quote from Nadella.
Competition also poses a significant risk for Arista. Failure to keep on top of enhancements in the space could cause buyers to move onto whichever company is providing the latest/greatest/fastest. By working with industry, offering the best in class support system, and working with the major alliances on future standards, I think Arista has a place in this industry for years to come.
My Arista Buy Price
Q1 earnings, released on May 5th, showed an expected reduction in revenues. This release gave shares a downward jolt in after-hours trading.
| 2019 Q1 | 2020 Q1 | Change | |
| Revenue | $595.4M | $523.0M | (5.3%) |
| Gross Margin | 64.5% | 64.7% | 0.2% |
| Net Income | $201.0M | $138.4M | (31.1%) |
GAAP EPS came in at $1.73, which beats estimates by $0.21. Revenue was down ~12% from the same period last year at $523M. We knew this would happen, and this was priced in. What I was looking for were consistent margins, and we got those (64.7% gross margin).
Unlike many companies, Arista also provided some guidance for the next quarter:
- Revenue between $520 million to $540 million
- Non-GAAP gross margin of 63% to 65%, and
- Non-GAAP operating margin of approximately 35%
If we assume that a slight uptick in revenue growth occurs in the third and fourth quarters (with the larger firms needing to upgrade their networks), I think we're looking at ~$2.2B in 2020 revenues, conservatively. This is roughly $270M less than in 2019. Margins appear to be consistent at Arista Networks, so leaving that at 35%, we have $770M in non-GAAP operating income.
With $1B in share repurchases authorized, and ongoing, Arista could buy back stock at these lower levels that would work out to a pretty level year in terms of EPS and get back to growth in 2021 as companies begin to release the clasps on their pocketbooks.
While I think the days of 30-50% growth are behind us, I do believe that 2021 will be an especially bright year for firms in the networking space, and Arista will benefit from that. At a reasonable 20% growth rate in 2021, Arista Networks would be looking at operating income of around $920M, or an EPS of $12.04 per outstanding share today. This, with no debt, and cash on the balance sheet, would easily command an 18x multiple, or $216 per share.
Hideaway Scores
Image: High-Quality Hideaway Scores via HighQualityHideaway.com
The Hideaway Scores are a methodology I developed over time to quantitatively bring the best stocks into view. It's actually how I came to find Arista Networks. In tracking A+, A, and B rated firms beat the market.
Conclusion
Arista Networks is a company in a growing, in-demand industry. Towards the end of 2019, things were looking a little bleak with customers like Microsoft slowing spending, but this firm might benefit from COVID-19 due to increased network demand.
My target buy price for Arista of $216 assumes a stagnant year this year, followed by a 20% growth in 2021. It also assumes that Arista does not buyback any stock (which it is doing), and it also assumes Arista trades at an 18x multiple, far below the 25 it is trading at today.
