Arista Networks Inc. (ANET, Financial) is one of the few tech companies that has had a relatively solid year in 2022. Its stock price has declined just 12.35% compared to the S&P 500’s 19.57% loss and the Nasdaq’s 31.07% tumble. Over the past 12 months, the stock is mostly flat.
The company has also continued growing its top and bottom lines, bringing its three-year revenue per share growth rate to 11.60% and its three-year earnings per share without non-recurring items growth rate to 37.4%.
Yet, despite its commendable success in recent years, this networking hardware company has a major risk in the form of the very same thing that is driving its positive results: it is heavily dependent on major cloud titans such as Meta Platforms Inc. (META, Financial) and Microsoft Corp. (MSFT, Financial) for its revenue.
About Arista Networks
Arista Networks specializes in designing multilayer network switches to deliver software-defined networking for large datacenter, cloud computing, high-performance computing and high-frequency trading environments.
In other words, its ideal customers are cloud titans like Meta and Microsoft because these are the companies that can best utilize Arista’s premium market-focused products such as high-speed switches that increase the speed of communications between racks of computer servers.
Arista also sells network management and security software and services, which customers can use to keep their networks running smoothly, identify potential threats and monitor user experiences.
Under the leadership of CEO Jayshree Ulaal, Arista has been gaining market share against competitors, which has sped up its growth. It has also been proactive in making value-added acquisitions, such as cloud-first networking company Big Cloud Networks (acquired in 2020) and unified cloud networking company Pluribus Networks (acquired in 2022).
Fairly valued with strong fundamentals
The GF Value chart estimates that Arista is fairly valued as of this writing, as shares trade around $126.45 compared to the GF Value of $126.50:
The price-earnings ratio of 38.95 is double the industry median valuation level, but below the stock’s own 10-year median price-earnings ratio of 40.33.
On the fundamentals side, GuruFocus gives Arista a financial strength rating of 8 out of 10, driven by a strong Piotroski F-Score of 6 out of 9, and a profitability rating of 10 out of 10, backed by operating and net margins that outperform more than 94% of peers in the hardware industry.
Cloud titans make up a significant portion of revenue
With Arista firing on all cylinders, it may seem like a no-brainer investment opportunity to play the growing Cloud market. In a risk-off stock market environment, it will likely experience less volatility than peers that were bid up into bubble territory in 2020 and 2021; while Arista’s stock did see an uptick due to the Covid stock bubble, it was not that extreme relatively speaking as the price-earnings ratio only went as high as 55.
However, one big risk for Arista is that a growing percentage of its revenue is coming from its largest customers. For example, when combined, the cloud titans made up 30% of Arista’s revenue at the beginning of the year, but heading into the end of 2022, they make up 45% of revenue. Microsoft alone has represented more than 10% of revenue since 2019.
The company is aware of the mercurial nature of this heavy dependence on large-cap customers and notes it actually saw a drop-off in revenue from the cloud titans in 2020 and 2021 compared to 2019, driven mainly by lower spending from Meta. Now that Meta is ramping up its capex spending plans for the rest of 2022 as well as 2023, the company could soon see an uptick in growth again, but if Meta were to reduce its capex in the years ahead, slower growth or even a downturn could follow.
The outlook is solid for now
According to Fortune Business Insights, the global cloud computing market is projected to be worth $480.04 billion in 2022 and grow to $1.71 trillion by 2029, representing a CAGR of 19.9%. Arista’s outlook could be even better because of its focus on developing products for the top players in the industry. As the cloud titans gain market share, Arista should continue gaining market share as well, barring the possibility that a competitor could swoop in and offer superior products.
According to estimates from Morningstar (MORN) analysts, though, Arista is not expected to keep up with cloud industry growth, at least in the near term. Analysts are calling for a three-to-five-year revenue per share growth rate of 12.36% and a three-to-five-year earnings per share without non-recurring items growth rate of 20.55%.
Perhaps this is due to the fact that Arista only deals with hardware sales and does not itself provide a popular cloud platform. If cloud utilization for its customers increases while its capex slows down, Arista may encounter trouble.
