Winning Product Strategy, Strong Competitive Sales Momentum, Veteran Technology Leadership, High Growth Cloud Computing Market
Technology and product leadership in high-growth cloud networking equipment space
Shares are sharply down from 52-week high and are 36% below Wall Street estimates
Strong operating cash flow, well capitalized balance sheet, zero debt and strong management team
Arista Networks, Inc. (NYSE: ANET) is a cloud networking company that provides extensible operating systems (EOS), network applications and 10/40/100 Gigabit Ethernet (GigE) switching solutions to companies in a wide variety of industries including service providers, financial services, government, Internet and media. Its customer base has grown from 570 in 2010 to over 2,700 in 2014 and some of its largest customers include technology giants such as Microsoft (MSFT), Facebook (FB), Yahoo! (YHOO) and eBay (EBAY). On the strength of its technology and service offerings, Arista has become a top player in the cloud data center industry and holds the second largest market share for Ethernet switch ports behind industry leader, Cisco Systems (CSCO).
Arista has solid growth prospects within the networking sector, with multiple new cloud customers driving revenue upside in 2015 and beyond, and a unique technological advantage that should drive strong, sustained financial performance over time, in the 10+ GigE sector growing at 14% annually. Arista has solid and rapidly growing customer traction, and its core focus on leveraging commodity silicon lowers capital and operating expenses, making its products more attractive to customers. As a result, recent share price weakness presents a strong buying opportunity.
IPO Exceeded Expectations
In June 2014, Arista Networks completed its initial public offering with 6,037,500 shares offered at $43 per share, priced above the initial filing range of $36-$40, with net proceeds of $238.7 million. Management used the proceeds to increase capitalization, prepay Singtel Innov8 Pte. Ltd. for a subordinated convertible promissory note and for other general corporate purposes. The main thrust of the IPO was to use funds to take on industry leader Cisco.
Opportunity: Stock Down Sharply From 52-Week High
As of market close on January 9, 2015, Arista Networks’ shares were trading at $66.42, up 54% from the company’s IPO price ($43) and up 21% from the company’s closing price ($55) on the first day of trading. Shares are, however, down from a 52-week high of $94.84 and offer considerable upside off current levels. At $66.42, shares were below the company’s 50-week moving average of $67.82 and 200-day moving average of $74.25.
Shares are partly down due to the 11/6/2014 lockup release of 50% of shares held by Arista employees who liquidated some of their stock holdings as common practice.
Arista shares trade at a price-to-earnings ratio of 74.5x and 43.4x cash flow, with a market capitalization of $4.3 billion. The story here is less about multiple to earnings but more about Arista’s ability to take on Cisco in the rapidly evolving cloud computing arena, with significant upside down the road if it succeeds in its mission. As the chart below shows, Arista has been strongly outperforming Cisco on recent sales and this upside momentum underscores the success of its strategy (technology, product, services, pricing and customer perception).
Arista is well capitalized, generates healthy cash flow, carries a low level of debt and has strong profit margins. While its P/E ratio of 74.5 may appear rich, it lags the 82% growth in operating income in Q3 2014 and reflects strong competitive sales momentum that should drive revenue significantly higher in the coming years.
Arista Networks does not pay dividends.
Average 12-Month Price Target Offers 36% Upside
The 25 analysts that cover Arista have a mean Buy recommendation and a mean 12-month price target of $90 per share which reflects 36% upside over current levels.
The table below shows recent analyst recommendations and share price targets.
Arista Strongly Positioned in Growing Cloud Networking Sector
Over the past decade, public and private companies have begun moving away from bulky physical storage options and turning to virtual cloud storage to cut costs and increase security. This has revolutionized the IT infrastructure at most businesses and opened up a new growth avenue for Arista Networks. In 2013, the cloud industry was worth $47.3 billion and is expected to grow to over $70 billion in 2015 and over $107 billion in 2017 as healthcare, media, energy, retail and other sectors turn to cloud computing and purchase high-speed switching equipment such as Arista’s GigE networking products.
Arista Networks offers four cloud network server configurations (Layer 2, Layer 3, L2 over L3 and Spline) that offer appropriate scalability and performance needs for enterprises with differing needs.
The company’s data center portfolio consists of seven families of Ethernet switches that vary in performance speed depending on the needs of customers. Arista’s products offer speeds of upto 100 gigabits with ultra-low latency and maximum reliability.
Arista products are all tied together with its fully programmable and highly modular EOS software that enables seamless integration of applications and cloud networks. The company’s unique EOS separates it from competitors and makes the company’s Ethernet switches more flexible, with lower total cost of ownership (TCO) for enterprise customers.
Arista recently introduced EOS+, a significant improvement over the company’s original EOS software that offers advanced levels of programmability, rapid application deployment and complete network integration, which reduces operational costs and lowers execution times. EOS+ is setup to easily integrate with solutions from many of the company’s technology partners.
Strategic Partnerships Push Network Virtualization and Product Development
Arista has a broad range of strategic partnerships with complimentary software, technology and solutions providers, and continues to expand its alliances in verticals that can benefit from the company’s cloud network solutions and help develop innovative solutions. In all, Arista has 44 technology partners and 5 development partners.
In August 2014, Arista and leading virtualization software company VMware (VMW) entered into a strategic partnership that extends their four-year relationship that’s focused on accelerating the shift to network virtualization in software-defined data center (SDDC) solutions. Arista deploys its EOS, network APIs and VTEPS technology with VMware’s NSX network virtualization platform to deliver innovative network-wide virtualization, custom programmability and simplified architecture.
Litigation Issue Does Not Pose Major Threat
On December 2, 2014, Cisco (CSCO) filed a patent and copyright infringement lawsuit against Arista Networks, claiming Arista violated 14 Cisco patents and indirectly pointing the finger at 11 Arista senior employees who previously worked for Cisco including four of seven Board members. Arista is reviewing details of the lawsuit and Arista CEO Jayshree Ullal (herself a former Cisco executive) saw the litigation as a ‘sad tactic’ being used by Cisco to thwart Aista’s success. The patent will likely not be overly negative for Arista.
Arista also faces an April 2014 lawsuit filed by major shareholder and co-founder David Cherlton and his cloud software company OptumSoft, that sued Arista over intellectual property violations related to usage of software development program TACC. OptumSoft earlier served as Arista’s sister company and licensed its TACC software to Arista with the agreement that any improvements to the software would have to be shared with OptumSoft. Cherlton claims Arista is not holding up its end of the licensing agreement. Cherlton is Arista Networks’ largest shareholder with a 22% equity stake.
Founded and Led by Technology Veterans
Jayshree Ullal serves as President and Chief Executive Officer and has over 25 years of executive experience. Ullal is in-charge of growing the company into a dominant force in the cloud networking business. Previously, she held senior positions with Cisco.
Kelyn Brannon serves as Chief Financial Officer and has over 25 years of finance experience at public and private companies. Brannon previously served as CFO for interactive commerce company Delivery Agent, telecommunications equipment maker Calix (CALX) and financial software maker Calypso Technology. She also served as Chief Accounting Officer for e-commerce company Amazon (AMZN).
Kenneth Duda is a co-founder and currently serves as Senior VP – Software Engineering and Chief Technology Officer. Duda is credited with developing the EOS operating system that all Arista products use. He also developed certain network virtualization specifications for Microsoft, a 3-D distribution system for online gaming and the Catalyst product line for Cisco.
Q3 Revenue Up 53%, Operating Income Up 82% on Global Customer Demand
For the three months ended September 30, 2014, Arista Networks had revenues of $155.5 million (up 53% over the year-ago quarter), gross profit of $101 million (up 55%), operating income of $33.9 million (up 82%) and net income of $21.9 million (up 84%), or $0.30 per share.
The increase in revenue was largely due to an increase in the sales of switch products and related accessories across four major verticals in the United States, EMEA and Asia Pacific.
For the nine months ended 9/30/2014, the company generated $98.7 million in cash from operations, up 143% from the year-ago 9-month period. Arista has strong cash flow, solid cash reserves and a clean debt-free balance sheet. With growing industry acceptance of its products, the company is poised to gain market share and grow revenue ahead of industry average growth in the coming years.
As of September 30, 2014, Arista Networks had $408.6 million in cash and cash equivalents, $199 million in total liabilities with zero debt and $492.9 million in total stockholders’ equity.
Positive Outlook for Q4 2014
For its fourth quarter of 2014, Arista expects revenue of $160 – $168 million with non-GAAP gross margin of 63% – 65% and non-GAAP operating margin of 22% – 25%.
Arista Networks was founded by networking industry veterans and is led by one of the best network technology management teams in the industry. The company has strong sales momentum and is beating out industry leader Cisco Systems in the rapidly growing cloud networking sector. Arista is very well capitalized, has zero debt and generates strong quarterly cash flow. At the $66 level, shares are considerably below their all-time high and offer at least 36% upside based on Wall Street analyst estimates. The company does not offer dividends so this is a capital appreciation play.