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Arista Networks: The Weak Guidance Doesn’t Change The Long-Term Potential

Arista Networks (ANET) reported slightly better than expected Q1 results, but the guidance for the next quarter disappointed the market. In the context of the impressive stock price increase since the beginning of the year, the 14.5% drop in the stock price isn’t so important. Even with a disappointing revenue growth forecast, the company still…

 

Slightly better than expected Q1 results, but the guidance for the next quarter disappointed the market. In the context of the impressive stock price increase since the beginning of the year, the 14.5% drop in the stock price isn’t so important.

Even with a disappointing revenue growth forecast, the company still outperforms many network vendors. In this article, I explain why this weak outlook is a temporary event rather than a structural issue.

Despite the drop in stock price, the market valuation still doesn’t offer any margin of safety.

Arista 7500R series

Disappointing guidance

Arista delivered slightly better than expected Q1 results. Revenue and GAAP gross margin at $595.4 million and 63.9%, respectively, both exceeded the midpoint of the guidance.

Of course, the weak outlook for the next quarter is due to the 15% drop in the stock price. Over the last several quarters, the company has been consistent in delivering a growth rate above 25%.

Chart

Data by YCharts

As the company is gaining scale, a declining revenue growth rate is expected. During the previous quarter, management indicated being comfortable with a 21% growth rate for 2019.

Thus, the forecasted Q2 growth rate of 16.3% was disappointing. During the earnings call, management justified the weak guidance with a slower activity from a few cloud titans:

“While 2019 is off to a decent start, we are experiencing somewhat of a speed bump in Q2 2019. We saw less than the normal order strength in late March and in the month of April. We are therefore forecasting slower growth in Q2 2019 from our normal and historical patterns. Some of the contributing reasons for this are one the massive cloud titan providers fulfilled in 2018 have led to a period of absorption in the first half of 2019. In particular, one cloud titan has placed most orders on hold for Q2 2019.”

The market reaction was strong as the stock dropped 14.5%. But considering the 47.5% stock price increase since the beginning of the year, the drop isn’t that significant. At $265, it still represents a 25.8% year-to-date increase.

Also, despite the disappointing forecast, management still expects revenue to grow by 16.3% in Q2. In contrast, Extreme Networks (EXTR) and Juniper Networks (JNPR) both reported a year-over-year revenue decline during this quarter. And both network vendors expect a revenue decline for the next quarter. Cisco (CSCO) didn’t release its earnings yet. The giant network vendor reported strong revenue growth over the last several quarters. But it’s safe to assume Cisco won’t forecast double-digit revenue growth for the next quarter.

The issue with cloud titans is temporary

Beyond the comparison with other network vendors, the most important aspect to consider is that the disappointing guidance isn’t due to structural issues. Instead, I see this development as temporary and normal volatility.

Arista’s strongest segment is the cloud titans, and it depends on a few big customers. In a previous article, I discussed Arista’s impressive marketing advantage due to its business with the cloud titans. But this type of business, besides penalizing gross margins due to the cloud giants’ negotiating power, involves volatility.

This volatility was favorable when the company delivered better-than-expected revenue growth. For instance, after the Q4 results, I highlighted in a previous article that Arista’s excellent results contrasted with negative results from other cloud data center providers. The concentration of customers also means some quarters will be less favorable.

But the big picture doesn’t change. Cloud titans invested with Arista to build scalable and integrated cloud data centers. There’s no technology change in the network data center area. The network designs are still based on the elegant and simple spine-leaf principle. Once the spine (core network) is in place, it’s easy and cheap to extend the network with a leaf switch. Also, applying the same existing network design and reusing integrated software provide economies of scale to the cloud titans when building data centers.

No margin of safety

Besides the temporary issues with some cloud titans, management discussed the soft business with security providers and the encouraging performance in the enterprise segment.

Taking into account these moving parts, management still expects its operating margin to reach at least 35% and indicated 21% is a fair tax rate to consider.

In my previous article, I had estimated a 25% growth rate in 2019. With a lower-than-expected growth rate during Q2, I now assume revenue growth will reach 18% in 2019. The table below shows some valuation ratios based on these assumptions:

Arista valuation assuming a 2019 growth rate of 18%

Source: Author

Even with a 14.5% drop in the stock price, and based on estimated 2019 results, the market still values the company at a PE ratio ex-cash of about 27.8x and an EV/revenue ratio of 7.6x.

Assuming a 25% revenue growth in 2019, the market still values the company at a PE ratio ex-cash of 26.2x.

Arista valuation assuming a 2019 growth rate of 25%

The growth rate, high margins, and a solid business justify the high ratios. But at the current valuation, I don’t see any margin of safety.

Conclusion

The weak guidance for the next quarter overshadowed the good Q1 results. Arista’s long-term potential doesn’t change, though. The volatility in the results is a natural consequence of dealing with a limited number of huge customers like cloud titans. There’s no change in the network technology, and the cloud giants have invested with Arista to build scalable and integrated architectures.

The strong results justify the high valuation ratios. But, even with the 14.5% drop in the stock price, the market valuation doesn’t offer any margin of safety.

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