Prior to the coronavirus overtaking the global economy, Arista Networks (ANET) was one of the hottest stocks in the IT sector. In contrast to many SaaS stocks, Arista Networks wowed the investment community due to the fact that despite being a hardware company, it clung to extremely high gross margins and critically, was profitable and generating tremendous earnings growth, which peaked when the Trump tax cuts settled in. Arista was billed as a “Cisco (CSCO) killer” and a long-term winner that would benefit as companies continued to invest in infrastructure that allowed them to adopt cloud-friendly infrastructures.
Here’s the problem: since the coronavirus began, companies have scaled back on spending. Not only have they slashed hiring and headcount, but they’ve scrapped capex budgets as well – and that includes IT spending on things like Arista products. Amid that backdrop, and due to the fact that unlike many other tech companies Arista doesn’t have a recurring revenue base that protects it from volatility, Arista has been dealing with jarring revenue declines. After reporting a disappointing second quarter and guiding to an even more disappointing third quarter, shares of Arista have dropped ~20%:
Now, here’s the good news: these problems aren’t Arista-specific. Arista’s principal competitor Cisco (CSCO) tanked ~12% after earnings, due to disappointing results stemming from soft enterprise spending from its own customers. What this means is that, at the very least, Arista isn’t losing pace with the rest of its industry.
Looking longer term, I’m favorably dispositioned toward Arista. The company has earned a “best in breed” reputation as a networking product that was specifically designed with the cloud in mind, whereas Cisco has the negative connotation of an older legacy product. The cloud isn’t going away – businesses aren’t investing into infrastructure in the near term, but they will have to as our computing demands continue to increase.
At the same time, there continue to be no near-term catalysts that can lift Arista higher. Arista’s latest management commentary doesn’t provide any hint of respite from the current demand environment (in contrast to many other enterprise companies, particularly in the software sector, that have signaled strong bouncebacks in June and July). Based on this, I think the best move is to continue to wait and watch. Considering that even after this stock price correction, Arista already trades at a ~23x forward P/E based on FY21 EPS consensus of $9.67 (+12% to FY20 consensus, but only flat to FY19; data from Yahoo Finance), I’d say there isn’t much of a safety net on the valuation front either.
Q2 download: the good news is that some supply constraints may push out some revenue into Q3
We can now dive into the specifics of Arista’s second-quarter print. Take a look at the results in the table below:
Arista’s revenue declined -11% y/y to $421.4 million, which is certainly better than Wall Street’s consensus of $530.6 million (-13% y/y) but still a disappointing continuation of the -12% y/y growth trend that we saw last quarter. With a weak macro environment, companies are focused on conserving cash and aren’t lining up to replace infrastructure products, which are delayable expenses in most cases.
Here is the bright news, however. It’s possible that Arista’s underlying Q2 demand could have been stronger than the -11% y/y decline that it generated, due to the fact that it was supply-constrained and had to push out fulfillment of some orders. Here’s some important commentary from CFO Ita Brennan on the Q2 earnings call.
In addition, while overall demand in Q2 was reasonably healthy, we continue to experience some COVID-19 related supply challenges, resulting in extended lead time and somewhat constrained shipments for the quarter.”
This isn’t exactly a whole lot of information to go off of, but we feel reasonably confident in estimating that “somewhat constrained shipments” means at least a few points of growth were pushed out from Q2 into Q3 when the orders are filled. Arista’s guidance – which calls for the same -11% y/y growth in Q3 – may have some points of opportunity by that logic, assuming of course that the company is finally able to catch up to its backlog by the end of the quarter.
And while Arista’s CEO Jayshree Ullal did offer the unsurprising commentary that many of its large customers (and cloud titans) are pushing out spending decisions to future quarters, “Arista experienced a cloud titan recovery and enterprise strength in Q2 offset by extended sales cycles in the campus sector.” In other words, there are some mixed signals – and while Arista remains uncertain about the overall demand picture, it’s not all unidirectionally bad news.
The other piece of good news is that Arista was able to hang on to its hard-won margins in the quarter. Arista’s pro forma gross margins remained flat at 64.7%, which is incredibly high for a company that primarily sells hardware. Similarly, pro forma operating margins held roughly constant at 38.1%.
We also remain encouraged by Arista’s fortress balance sheet. As of the end of the June quarter, Arista held a whopping $2.78 billion of cash and marketable securities on its books, worth roughly 17% of its market cap and also just over a year’s worth of revenue. This cash also comes free and clear of debt. This liquidity gives Arista plenty of flexibility to manage through the current crisis and re-invest in growth, and also take advantage of a lower share price to continue repurchasing shares, on which it has a ~$0.5 billion authorization left to go on its existing $1 billion share buyback approval.
Arista is far from doomed forever. As the leading provider of cloud-friendly networking infrastructure, Arista is closely tethered to the trends that are driving the modern tech and computing landscape. Its problems are thankfully not self-isolated, and we’ve seen similar cautious commentary around Cisco, Arista’s biggest rival. The fact that Arista was supply-gated and couldn’t fulfill all its shipments in Q2 also suggests that underlying demand may be stronger than its current financials are showing.
Stay cautious for now, but keep on the lookout for a buying opportunity if shares drift meaningfully lower.
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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.