As the big tech companies are only at the beginning of the AI race, Arista Networks appears to be well-positioned to benefit from this competition, providing products and services to numerous tech companies, including cloud titans like Microsoft and Meta Platforms.
Summary
- Arista Networks has grown its market share to 23% over the last decade by providing a broad range of products and services that focus on cloud and data centres, network adjacencies, and network software to cloud titans, cloud speciality providers and others, including Meta Platforms and Microsoft.
- Arista's product and service range, as well as its client base, place it in a position to benefit from the advancements in the AI industry.
- The company holds a solid financial position, low debt and higher profitability ratios than the industry average.
- The strong earnings growth in 2022 has led the company stock to jump into overvalued territory. A potential pullback in the stock price may be viewed as an opportunity to invest in Arista Networks at better valuation multiples.
Company overview
Arista Networks is renowned for utilising software-driven solutions to create faster and more efficient networking solutions, thereby pushing the boundaries of traditional networking. Its products have won numerous industry awards, and the company's focus on software-driven solutions has set it apart from traditional competitors.
Arista serves five verticals: cloud titans (customers deploying over a million servers), cloud speciality providers, service providers, financial services, and the remaining enterprise sector. Among Arista's clients are six of the largest cloud service providers worldwide in terms of annual revenue.
Arista boasts a broad range of products focusing on cloud and data centre products, network adjacencies, network software, and services. Its flagship product, Arista EOS Network, is a software-based solution that enables programmability across all layers of the network stack, simplifying the management of network traffic flows, automating network operations, and improving reliability.
Moreover, Arista also offers integrated security and monitoring in a single solution. Its CloudVision platform enables organisations to monitor network traffic, identify potential threats and take immediate action. These innovative solutions are integrated into their Client-to-Cloud portfolio, enabling the company to capture significant market share, outpacing competitors such as Cisco.
Over the last decade, Arista's market share has grown from 3.5% to 23.1%, while its key competitor's Cisco market share has decreased from 78.1% to 39.4% in dollar terms in the same period.
Source: Arista Networks Q4 2022 presentation
Furthermore, Arista has managed to increase its market share by keeping its profit margin superior to that of Cisco (35% versus 26%, respectively).
High exposure to key clients
One of the risks worth highlighting is Arista's relatively large exposure to some of the biggest names in the tech industry. Its two largest clients (also known as cloud titans) – Meta Platforms and Microsoft – faced major macro headwinds in 2022 and, as a result, lost 64% and 29% of its stock value. Meta Platforms accounted for 25.5% of Arista's revenues in FY2022 by spending 1.12 billion USD for its products and Microsoft – 16%. Although these clients are not expected to reduce their spending significantly in 2023, such a high concentration of revenues could be a risk for Arista in the future. A high concentration of revenues with a small number of clients leads to the potential for bargaining power to be exercised by the clients or simply being susceptible to the business cycles of the said customers.
On the other hand, given the relatively high barriers to entry for new players, Arista's close collaboration with the cloud titans may give it a competitive advantage. Arista has built long-standing and deep relationships with these companies based on trust, therefore working its way to becoming a backbone of the Artificial Intelligence industry.
Arista Networks' potential in AI
In 2022, the global market for artificial intelligence was worth USD 136.55 billion, and it is expected to grow at a compound annual growth rate (CAGR) of 37.3% between 2023 and 2030. Through their ongoing research and development efforts, tech giants are spurring the adoption of cutting-edge technologies in various industry sectors, including automotive, healthcare, retail, finance, and manufacturing. And as they migrate their IT infrastructure to the cloud, Arista Networks is among the key companies they turn to as parts design partners and trusted engineers.
Both of Arista's key clients are top players in the artificial intelligence industry. Microsoft – the second largest cloud infrastructure provider in the world – is planning to invest billions of dollars into the AI industry, and it recently acquired the creator company of ChatGPT – the most popular mainstream AI (and the fastest-growing in history) app in the world. What's more, at the end of 2022, Microsoft announced its plans to build an AI supercomputer, which is expected to be one of the largest in the world when it's finished.
Without going too much into technical details, Arista co-developed its Tomahawk-3 switches with Meta and its 7800 AI Spine is now called a backbone for AI-intensive tasks offering a combination of higher power efficiency, high performance and reliability. Meta has also announced that it will revamp its data centre architecture to handle the growing use of AI workloads in the upcoming years.
Valuation and other financial ratios
Despite macroeconomic uncertainties and a weaker spending environment affecting even cloud and data centre demand, Arista managed to report 4,381.3 million USD in revenues for FY2022, showing a 48.6% increase from a year before. At this point, Arista is not only enjoying growing revenues, but the rate of revenue growth has accelerated in recent years, with the current 5-year CAGR standing at 21.6%.
The company is in a healthy position from the leverage perspective. It has zero long-term debt, and its total liabilities are just 38.67% of its equity. The company has a net debt of -2.96 billion USD and 3 billion USD in cash, indicating that it may have enough liquidity to face the potential macroeconomic challenges. Furthermore, Arista may be in a better position than other leveraged companies in the environment of elevated interest rates.
The company's profitability ratios are considerably higher than the sector median. Its 12-month trailing EBITDA margin is 36.29% versus the 9.40% sector median, while its net income margin for the same period was 30.87% versus the 2.71% sector median. Similarly, the return on Arista's common equity is 30.51% versus the 2.65% sector median, and its return on total assets is 19.96% versus the 0.70% sector median.
From the valuation perspective, Arista seems overvalued compared to its industry peers and the broader S&P500. At the current stock price of 159 USD and FY2022 EPS of 4.58, the stock trades at a P/E of 34.84, which is considerably higher than the industry average and S&P 500.
Arista may have a significant competitive edge, justifying its valuation at a premium to peers. For example, while the 5-year P/E median for Arista is 31.29 (not so far away from the current P/E of 34.84), the industry's 5-year P/E median is only 21.77. However, there may be short-term risks that could trigger a price correction, such as the management's projected decline in gross margins. Specifically, the company forecast a slowdown in its non-GAAP gross margin to around 60% in Q1 2023, a drop from 63.9% in the same quarter the prior year. This projection may raise concerns about the company's future profitability. Analysts predict a rise in the forward EV/Gross Profit ratio to 14.4, which exceeds the company's trailing EV/Gross Profit ratio of 12.6. While the expansion of the operating margin from 38.3% to 40% in Q1 2023 may be reassuring, the lower efficiency in the gross margin outlook may be a risk that should be carefully monitored.
Arista Networks stock
Arista stock has grown four times since the stock market drop in March 2020 due to Covid-19. In March 2023, Arista stock reached a new all-time high surpassing the 170 USD level and may now return to its support level of 120-130 USD per share before resuming its uptrend.
Source: TradingView
Conclusion
While the big tech companies are only at the beginning of the AI race, it may be difficult to evaluate the real potential of this industry. Still, it may be rather clear that it has the potential to become a significant part of the tech world and disrupt the infrastructure as we know it today. Arista Networks holds the potential to become the backbone of the AI disruption supported by a healthy balance sheet and large profit margins.
The company may currently look overvalued thanks to a strong fiscal 2022, which has seen the stock rally to new all-time highs. As forecast by management, slower growth in 2023 due to macroeconomic uncertainties could cause the share price to pull back in the following months. Such a scenario could be seen as an opportunity to buy Arista Networks shares at better valuation multiples.
Santa Zvaigzne-Sproge, CFA, Head of Investment Advice Department at Conotoxia Ltd. (Conotoxia investment service)
Materials, analysis, and opinions contained, referenced, or provided herein are intended solely for informational and educational purposes. The personal opinion of the author does not represent and should not be constructed as a statement, or investment advice made by Conotoxia Ltd. All indiscriminate reliance on illustrative or informational materials may lead to losses. Past performance is not a reliable indicator of future results.
CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 73.18% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
