Arista Networks Is Back On Its Feet, But Recovery Has Already Been Priced Into The Stock

Summary

• Arista shares have recovered after a difficult 2020, and have strong upward momentum.
• Arista returned to growth in Q4, achieving 17% y/y growth after declining -11% y/y in Q3.
• As companies and particularly IT departments return to investment mode, Arista may benefit from deferred purchases in 2021.
• However, Arista's ~31x forward P/E ratio already appropriately prices the stock for its improving performance.
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Though most technology companies benefited tremendously from pandemic-related tailwinds and increased internet usage in 2020, Arista's (NYSE:ANET) 2020 was a completely different story. Frozen investment cycles, paused IT budgets and a re-prioritization of IT departments to focus primarily on enabling remote work hurt sales of Arista hardware dramatically last year. But in Arista's most recent fourth quarter, we can begin to see the light at the end of the tunnel, with the company returning to growth and showing hope for recovery in 2021.

Shares of Arista have already baked in a good deal of optimism. Though most tech stocks are down for the year, Arista is trading near 52-week highs and is up ~9% year-to-date.

Data by YCharts

As a reminder for investors who are less familiar with this stock, Arista made a name for itself by making and marketing cloud-native networking products. Its products like routers and switches boast higher performance and much higher ratings from tech analysts like Gartner than its primary rival Cisco (CSCO), which for many years was the dominant incumbent in the networking hardware market. Arista's CEO of nearly 15 years, Jayshree Ullal, even served a stint as a top lieutenant of former Cisco CEO John Chambers before defecting to Arista.

Overall, Arista estimates its TAM to reach $33 billion by 2025 (so at the company's current $2.3 billion revenue scale, the company still has ~93% of its available market up for grabs). Year after year, Arista's lead in the networking market over Cisco continues to grow, as shown in the chart below:

Figure 1. Arista market shareSource: Arista Q4 investor presentation

Recovery in 2021 will help to illustrate if Arista can continue to cement its lead. For Q1, Arista has guided to an impressive $630-650 million in revenue, representing 20-24% y/y growth (versus 17% y/y growth in Q4), and far above the $608.1 million (+16% y/y) that Wall Street consensus called for. There are strong tailwinds to support this return to growth: though IT spending took a breather in 2020, internet and cloud usage surged. At some point, cloud infrastructure will have to keep up with increased usage - in other words, there's strong evidence that there's robust pent-up demand for Arista products that can drive this growth recovery in 2021.

Here are other specific drivers that Arista has cited as growth opportunities for 2021:

Figure 2. Arista 2021 growth opportunities Source: Arista Q4 investor presentation

Yet at the same time, I do feel that Arista's recent rally has already priced in a good deal of this recovery. At current share prices near $308, Arista trades at a 30.6x FY21 P/E versus Wall Street's $10.07 pro forma EPS consensus for the year (+11% y/y), or a 27.3x FY22 P/E (12% y/y) versus consensus of $11.29 for the following year. Given the company's projected earnings growth has slowed to the low teens, I don't think a P/E multiple in the ~30x range is warranted any longer.

The bottom line here: it's a good idea to keep an eye on Arista stock and buy on dips, because this is a company that faces easy comps in the current year and has substantial drivers to drive a pickup in business. Only buy it, however, if and when prices become more favorable (at a $260 level, which is where the stock traded in November before a monthlong rally, Arista would be valued at a more reasonable ~23x FY22 P/E ratio).

Q4 download

Let's now cover Arista's latest quarterly results in greater detail. The Q4 earnings summary is shown below:

Figure 3. Arista Q4 resultsSource: Arista Q4 earnings release

Arista saw its revenue grow 17% y/y to $648.5 million in Q4, comfortably beating Wall Street's $630.3 million (+14% y/y) expectations. This also represents a massive acceleration versus a -8% y/y decline in revenue in Q3 and a -11% y/y decline in Q2. We note one thing, however: back in Q3, the company had cited that it was facing supply constraints, so it had a backlog of orders pushing out from Q3 to Q4.

Yet even here in Q4, Arista continued to cite ongoing supply chain challenges that are causing backlog to push even further to Q1. Per CFO Ita Brennan's commentary on the Q4 earnings call:

Total revenues in Q4 were $648.5 million, up 17.4% year-over-year and well above the upper end of our guidance of $615 million to $635 million. While we continue to strive for improvements on the supply chain front, shipments remained somewhat constrained in the quarter, with some COVID second and third wave-related disruptions."

The boost that backlog can give to Q1 revenue is a considerable driver behind Arista's expectations of continued acceleration to 20-24% y/y growth in Q1. The company did warn in its guidance notes, however, that as Arista's results in 2020 strengthened in Q3/Q4 that comps would begin to get difficult in the second half of FY21, and y/y growth won't be as strong as in Q1.

Arista also managed to hold its strength from a margin perspective, even despite the revenue declines in Q2-Q3. As can be seen in the chart below, Arista's FY20 full-year gross margin at 65.0% was the highest in five years; its operating margin for the full year at 37.7% fell only half a percentage point lower than in FY19.

Figure 4. Arista margin trendsSource: Arista Q4 investor presentation

We note that Arista's high-60s gross margin is incredibly rich for a company that sells almost purely hardware. Over time, this should help Arista to scale and continue to drive profitability growth. EPS of $2.49 grew only 9% y/y - if the company can achieve mid-teens revenue growth while holding operating margins flat to FY20, it should be able to beat Wall Street's expectations for just 11% y/y EPS growth in FY21. This is especially true if the company continues to drive healthy share buybacks: the company spent 54% of its $735 million in cash flow from operations on buybacks in 2020, and there's a hefty $2.88 billion of cash left on Arista's balance sheet (which is a sizable chunk of its ~$23 billion market cap).

Key takeaways

There's certainly a case to be made for a strong Arista recovery in 2021, but it looks like Arista's stock is already pricing in that scenario at the company's current >30x forward P/E ratio. Keep a close eye on this stock and be ready to strike if volatility hits, but don't rush into buying Arista on the upswing.

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.