BUY-rated Arista Networks Inc. (NYSE: ANET) rallied by 13%, or by $28, on 11/3/20 in a rising election-day market as the cloud networking company beat consensus estimates for 3Q20 sales and non-GAAP EPS. After multiple quarter of soft product sales, Arista delivered double-digit sequential product growth. Services revenue continued its strong double-digit annual growth year-to-date and helped hold the annual decline in total sales to high single digits.
CFO Ita Brenan noted that the company has experienced continued improvement in underlying business trends during the quarter, with the company working with supply chain partners and its customers to navigate the COVID-19 environment. Arista is helping customers migrate from legacy architectures to cloud network, having shipped a cumulative 40 million cloud networking ports from inception through 3Q20.
That market has been quiet as branch offices sit idle and companies hold off on new investments. Campus is now showing signs of life, and Arista has expanded its cognitive campus portfolio with new platforms, including the 750 series modular chassis and the 720 series fixed port switch.
Late in September, Arista announced it was acquiring Awake Security; the deal closed in October. Awake offers a network detection and response (NDR) platform that combines artificial intelligence with human expertise to autonomously hunt for and respond to internal and external network threats. Security has become a massive priority in the network space, and Arista joins network company industry leaders Cisco and Juniper in integrating additional security into its offering.
Arista appears primed to swing to annual revenue and EPS growth in 4Q20, after four quarters of negative top-line comps. Arista is financially strong; debt is equal to less than 5% of cash, which is growing rapidly. The company’s technology has proven disruptive in the marketplace for large enterprise and cloud service provider solutions. As the pandemic recedes, we expect Arista to extend its success to new opportunities, including campus and SME enterprise.
ANET is up 20% year-to-date in 2020. ANET declined 4% in 2019, including a 24% selloff on 11/1/19; the peer group of cloud, social, mobile and internet service companies in Argus coverage was up 51% in 2019. ANET shares began trading at $43 following their IPO on June 6, 2014.
For 3Q20, Arista reported revenue of $605 million, which was down 7% year-over-year though up 12% sequentially. Non-GAAP earnings of $2.42 per diluted share for 3Q20 declined 10% annually while rising $0.31 sequentially from 2Q20. Non-GAAP EPS easily exceeded the consensus of $2.21. While management does not furnish formal non-GAAP EPS guidance, line-item guidance had pointed to EPS in the $2.15-$2.25 range.
Former growth star Arista began to experience revenue softness in 4Q19, before anyone had heard of the pandemic. At that time, the company’s cloud titan customers paused new purchases to digest and integrate past investments. Long reliant on cloud titans, service provider and large enterprise customers, Arista in 2019 pushed into the campus (small enterprise) sector.
The pandemic has idled office buildings, but also accelerated development of the fully digital economy. In its second quarter, Arista experienced a modest cloud titan recovery and enterprise strength, partly offset by softness in campus and international service provider.
In 3Q20, Arista experienced strengthening demand on a sequential basis in multiple customer classes. CEO Jayshree Ullal noted that Arista recorded a record number of new customer wins and million-dollar customers in the quarter, which she called ‘a direct result of our momentum in the enterprise vertical and campus traction’ in the quarter.
After multiple quarter of soft product sales, Arista delivered double-digit sequential product growth. Product revenue of $480 million (78% of total) was down 13% annually but up 14% sequentially. Services & software revenue (22% of total) continued its strong double-digit annual growth year-to-date, growing by 28% annually and 5% sequentially.
Enterprise has again consistently become Arista’s second-largest customer category, according to the CEO, behind Cloud Titans. For 3Q20, cloud titan revenue of $224 million (37% of total) increased 4% on a sequential basis. Enterprise & financial services (37% of revenue) posted 18% sequential revenue growth, while carriers & tier 2 cloud (26% of total) grew revenue by 16% sequentially.
In terms of regional split, U.S. revenue (75% of total) declined 14% annually while growing 4% sequentially. Led by improving Asian demand and modest European recovery, international revenue (25% of total) increased 27% year-over-year and jumped 47% on a sequential basis from 2Q20, when international was just 19% of revenue.
After a ‘decade of momentum’ in could networking, Arista in the past four quarters has been impacted by cloud titan volatility, COVID pressures in the enterprise space, and impacts from deferred revenue recognition. As the economy begins to normalize even within a pandemic, Arista has shaped its strategy for addressing its $30 billion total available market. Despite these challenges, Arista expects to emerge stronger and return to double-digit growth in 2021 and to deliver consistent growth in the years ahead.
The CEO identified three key product lines as key to multi-year growth. In the core cloud and data center markets, Arista looks to build on its flagship Arista EOS with its leaf & spine topology (differentiated from traditional spanning tree architectures). The second opportunity is spanning carrier through cognitive campus. Arista sees opportunities in routing in core, spine and edger for tiers 1 through 3 service providers. In campus, Arista sees opportunities in the cognitive unified edge for wired and WiFi endpoint, new IoT devices, and leaf & spine networking.
The third opportunity is network software & services based on subscription models including CloudVision, Cloud EOS router for multi-cloud, big switching monitoring, and the recently acquired Awake Security business. In the services & software space, customers are ‘driving mandates for network automation and monitoring visibility across their dataset.’
Arista announced the Awake Security deal in September, and it closed in October. Awake offers a network detection and response (NDR) platform that combines artificial intelligence with human expertise to autonomously hunt for and respond to internal and external network threats. Awake executives, including CEO Rahul Kashyap, believe network security has lagged overall technological innovation, resulting in poor visibility into threats.
Legacy security solutions are difficult to adapt to current rapidly evolving security attacks. Large, complex and dynamic networks with thousands of endpoints and users require secure network visibility across client-to-cloud directories and assets for a complete security picture. The new class of NDR security solutions is required in this environment, and Awake is a proven leader in this emerging space.
By providing ‘rich visibility into the environment’ and the ability to analyze predictively, NDR offerings complement other elements in a comprehensive ‘triad’ of security. This includes Endpoint Detection Response (EDR) solutions provided by companies such as Crowdstrike, as well as Security Information and Event (SIEM) solutions from companies such as Splunk. Collectively, these capabilities provide unparalleled security operations center (SOC) visibility in network operations.
CEO Ullal believes network security is going through a metamorphosis from point security, to proactive and predictive secure networking. Arista’s CloudVision, combined with Big Switch’s observability and Awake’s autonomous spec hunting, create a modern integrated security suite.
Security has become a massive priority in the network space, and network companies Cisco and Juniper are among the industry leaders. These companies have also seen continued growth in security while their switching & routing revenues have stalled. We also believe Arista’s acquisition of Awake enhances the cloud company’s integrated security offering and makes it a more complete competitor against the network giants.
The CEO stated that cognitive campus is a priority for Arista. The company expects its campus business to double by year-end 2021. At the time of the 3Q20 results report, Arista highlighted new product launches to serve this market. New cognitive campus platforms include the 750 series modular chassis, which management called the first 100 gig-ready, high-density modular power-over-Ethernet switch on the market. According to Arista founder and CDO Andy Bechtolsheim, the 750 has 400 Gbps uplink throughput, or 5-times the performance of the nearest competitor product. A single 750 chassis supports nearly 400 WiFi access points, according to the CDO. Arista also introduced the 720 series 96-port fixed switch.
Notably, midpoint revenue guidance suggests that Arista will swing back to positive top-line comps in the current quarter.
EARNINGS & GROWTH ANALYSIS
Revenue came in above the $580 million midpoint of management’s guidance of $570-$590 million, and above the $580 million consensus forecast.
Non-GAAP earnings of $2.42 per diluted share for 3Q20 declined 10% annually while rising $0.31 sequentially from 2Q20. Non-GAAP EPS easily exceeded the consensus of $2.21. While management does not furnish formal non-GAAP EPS guidance, line-item guidance had pointed to EPS in the $2.15-$2.25 range.
Arista generated non-GAAP earnings of $9.74 per diluted share in 2019, up 22% from $7.97 in 2018.
Based on these and other line-item inputs, we believe Arista can earn around $2.45-$2.55 in 4Q20, which would be up 10%-12% year-over-year.
FINANCIAL STRENGTH & DIVIDEND
OuThe company’s rapid sales growth, which is increasingly software-driven, throws off substantial cash.
Debt for pre-public Arista was $41 million at the end of 2015 and $43 million at the end of 2014.
The company repurchased no stock in 2Q20 amid COVID-19-related caution, and is resuming its shareholder return program cautiously. Purchases will be made opportunistically and will be funded from working capital.
The company has never paid a dividend, and we do not expect it to implement one over the next two years.
MANAGEMENT & RISKS
Ita Brennan is the CFO. Manny Rivelo is chief sales officer. In March 2019 Anshul Sadana was promoted to COO from chief customer officer; that role is now being filled by John McCool.
Andreas Bechtolsheim, an Arista founder, has served as the company’s chairman since 2004 and as its chief development officer since 2008. Mr. Bechtolsheim was previously the co-founder of Sun Microsystems, a maker of computers and computer software, which was acquired by Oracle in 2010. He also co-founded Granite Systems, a producer of Gigabit Ethernet switches, which was purchased by Cisco in 1996, and served in various executive positions at Cisco following the buyout.
The pause in spending by leading cloud customers is cause for concern and bears monitoring. We see no evidence of competitive share loss, however, and believe the digestion phase among leading customers is part of the business cycle in a fast-formulating cloud data center environment.
Arista was long involved in patent litigation with Cisco Systems, but in August 2018 the two sides signed a binding term sheet to end the litigation. By paying $400 million to Cisco, Arista effectively acknowledged some infringement. Still, we expect Arista to benefit from the resolution of this multiyear litigation against a cash-rich giant.
Arista investors face customer concentration risk, as several large customers account for a significant portion of the company’s revenue, as well as risks from intense competition and changes in technology that could reduce demand for the company’s products. Arista may also be hurt by supply shortages and adverse currency movements.
Arista Networks is a leading supplier of cloud networking solutions for internet companies, cloud service providers, and next-generation data centers. It generates the largest portion of its revenue from switching products that incorporate its Extensible Operating System (EOS) software.
Compared to a diverse peer group that includes equipment vendors as well as cloud service providers, ANET trades at premiums that we believe are well deserved given its disruptive business model.