Arista Networks share: A "twenty-bagger" 10 years after IPO
Network equipment provider Arista Networks is celebrating its 10th anniversary on the stock market in a few days. The company has performed fantastically since its IPO in 2014, increasing in value by more than 20 times. Arista's stock is currently within a few percentage points of its all-time high.
Arista is also a perennial favourite in my portfolio. I have held the Cisco rival's shares in the investable sample portfolio since the beginning of 2018, this position has gained more than 500%.
I am particularly pleased with this performance, because the timing of my investment in Arista at the beginning of 2018 was anything but fortunate. I suffered two years of book losses. The current book profits were only possible thanks to a lot of patience and the disciplined implementation of my HGI investment strategy.
Great Arista numbers for Q1 2024
Arista Networks once again reported incredibly strong Q1 2024 numbers, beating analyst expectations by a wide margin, especially on guidance.
Q1 2024 revenues of 1.571 billion USD represent growth of over 16% year over year.
This revenue growth is particularly remarkable when one considers the exceptionally good comparables for 2022 and 2023. In those two years, Arista's revenues jumped by almost 100%.
Despite its rapid growth, Arista has been exceptionally profitable for years. The gross margin in the first quarter was over 64%. Operating margin was 47% (non-GAAP) compared to 41% in the same quarter last year. Q1 is seasonally one of the weaker quarters of the year.
Arista's net income for the first quarter was 638 million USD, representing an excellent net margin of 41%. Non-GAAP earnings per share increased 39% to 1.99 USD in Q1.
Arista's mid-term goals
Arista's management, led by CEO Jayshree Ullal, has always been known for its cautious guidance. At the beginning of last year, it was forecasting revenue growth of 25% by 2023. In the end, shareholders enjoyed 34% growth.
In November 2023, Arista published new long-term targets. By 2027, the total addressable market (TAM) is expected to grow from 37 billion USD to 60 billion USD, in part by developing new revenue streams. For the period 2022-2027, revenue growth was forecast to average around 15%.
However, the initial guidance for 2024 was for comparatively meagre growth of 10-12%, following exceptionally strong growth in 2022 and 2023. After the strong first quarter, this forecast has now been revised upwards to growth of 12-14%. Given the very confident and optimistic statements on the Q1 earnings call, I am convinced that we can expect a whole series of beat+raise quarters in 2024 and that 15-20% growth will ultimately be achieved.
It is always interesting to take a long-term view of the competitive situation between Cisco and Arista. At the time of Arista's IPO 10 years ago, Cisco had almost 80% of the market for data centre switches, which are important network interconnects. At the time, Arista was a small underdog with less than 5% of the market.
Exactly 10 years later, Arista has overtaken market leader Cisco. If you look specifically at the latest generation of high-speed switches, Arista's leadership is even more pronounced.
Opportunities and Risks of the AI hype for Arista
Microsoft and Meta Platforms have been Arista's biggest customers by far for years. The cloud titans, with their large investments in data centres, have together accounted for up to 40% of Arista's total revenue in recent years. Overall, this means that the company is heavily dependent on the two cloud titans.
At first glance, this sounds like a nasty cluster risk for the future. But Arista's technology leadership means that there is a degree of interdependence. Meta and Microsoft have not only been Arista's biggest customers for years, but also important strategic partners in product development. However, this customer concentration is dangerous. If Microsoft and Meta fail in their ambitious growth plans in the AI age, Arista would also have a big problem.
However, the current AI hype is also creating additional opportunities for Arista. It looks like new AI-based services such as ChatGPT will significantly change the way we use the internet. This will require much more powerful cloud infrastructure in data centres to run these AI services successfully and at high performance.
According to Arista management, an AI workload requires not only expensive GPUs (made by Nvidia), but also about three times the network bandwidth of a comparable conventional service. AI could therefore bring Arista Networks a golden age that is difficult to quantify. According to its published business plan, Arista aims to generate $750 million in additional revenue from AI by 2025. That would be a good 10% of total revenue.
In recent weeks, some analysts have suggested that Arista could face increasing competition from Nvidia in the future. Arista's management made it clear on its Q1 earnings call that it does not see Nvidia as a direct competitor, at least not now and not in the foreseeable future. Instead, the company could benefit from Nvidia's success by selling complementary Arista products.
Share Buyback at Arista
Arista has been highly profitable for a number of years and has a strong balance sheet. At the end of March 2024, the company had over 5.4 billion USD in cash.
Since 2019, the company has already spent $2 billion on share buybacks. This has limited dilution to around 1% per year on average over the past 6 years.
In May 2024, a further 1.2 billion USD share buyback program was launched, allowing shares to be repurchased until 2027.
Whether this makes sense at this point in time is another question. In general, I don't think it's necessarily a good idea for a company to buy back its own shares at peak prices. Which, of course, raises the question of the current valuation of Arista's shares.
Valuation of Arista Stock
At a share price of around 310 USD, Arista has an enterprise value of around 91 billion USD. Based on expected sales in 2024, this implies an EV/sales ratio of around 14. The P/E ratio is over 40.
This means that the Arista share has become much more expensive over the last 12 months. I now consider this price to be very ambitious. Even when you consider that this is a technology leader with exceptionally good margins, rapidly rising profits and above-average pricing power.
Conclusion
I fear that Arista's shares will come under pressure as soon as (sooner or later) the AI hype enters its disillusionment phase. Not only Nvidia, but also Arista's main customers (the cloud titans) are then likely to struggle to meet the market's inflated expectations.
I have therefore reduced the overweight of Arista shares in my investable sample portfolio in recent weeks. I am determined to hold the remaining position for the long term. This is because I actually see a realistic chance of a tenbagger for my investable sample portfolio by 2028.
This would require a further 60% increase in the value of the Arista share over the next 5 years. I think that is quite possible. However, it may well be that the share will be considerably cheaper on its way to my tenbagger than it is today. So for me, Arista is just a good hold position today.
If you want to follow Arista with me in the future, you can
*Disclaimer:
The author and/or associated persons or companies own shares in Arista Networks. This article is an expression of opinion and does not constitute any investment or financial advice.
Great company but too expensive for me