Nobody is perfect when it comes to investing. I wish I were, but I am far from it. But one thing I can take pride in is the fact that, when I am wrong, I end up admitting it. In an article that I published in late October of last year, I made an admission regarding a technology company known as Arista Networks, Inc. (NYSE:ANET). For those who don’t know, Arista Networks focuses on providing its customers with cloud networking capabilities. It does this primarily through its Arista Extensible Operating System (or EOS). This platform helps with establishing workflow automation for customers, while also providing tools and applications that help users monitor, detect, and report on network issues when they arise. It offers top of the line security as well.
For some time leading up to that October article, I had been rather neutral on the business because of how pricey the shares were. But as top line and bottom line performance continued to come in strong and as shares appreciated materially, I eventually acknowledged that I had been too harsh on the firm. I ended up upgrading the company to a ‘buy’ and, since then, that’s precisely what shares have done. While the S&P 500 is up 19.2%, shares of Arista Networks have jumped almost double that, clocking in a return of 37.7%. Of course, we do need to be mindful of how pricey the stock does become.
At some point, it risks becoming overvalued. The good news for shareholders is that we will soon get a look at that picture. I say that because, on February 12, after the market closes, the management team at the firm is expected to announce financial results for the final quarter of the 2023 fiscal year. If analysts are correct, year-over-year growth should be robust. And absent any shift to guidance that would be disappointing for the next year or two, it looks as though additional upside could even be warranted from here. So because of that, I’m keeping the company rated a soft ‘buy’.
Shares aren’t cheap
In my last article about Arista Networks, I did cover some of the most recent financial performance of the business. My goal, in this case, is not to rehash that data since we have not had new results come in. I do encourage you to read the aforementioned article linked above. In short, however, it is important to note just how robust growth has been. Revenue in the first nine months of 2023, for instance, totaled $4.32 billion. That’s 39.1% above the $3.11 billion generated one year earlier. Most of that growth came from a 42% surge in what management calls ‘Product’ revenue. This largely consists of sales of switching and routing products that the company sells, as well as network applications that are related to these offerings. The jump in revenue, according to management, was driven by a rise in shipments of its switching and routing platforms.
This rapid growth is because of significant investments being made by companies in what management has referred to as a $51 billion market opportunity. That market is the cloud networking market. And that opportunity is expected to grow to that size by 2027 from the $31 billion that it stood at last year. Significant investments being made in data centers, including by its largest customer Meta Platforms, Inc. (META), which accounted for 26% of overall revenue the last time it was reported, should bode well for the enterprise. In fact, just recently, the Facebook parent announced that they planned to spend between $30 billion and $37 billion on digital infrastructure this year. That’s a $2 billion increase over what the firm had previously anticipated for 2024. And with other major firms also spending in this market, it’s likely that Arista Networks will continue to reap the benefits.
With higher revenue also comes higher profits. In the first nine months of 2023, Arista Networks generated net profits of $1.47 billion. That’s well above the $925.4 million reported one year earlier. Operating cash flow more than tripled from $452.3 million to $1.51 billion. If we adjust for changes in working capital, it nearly tripled from $496.6 million to $1.49 billion. And lastly, EBITDA expanded from $1.10 billion to $1.67 billion.
As I mentioned already, after the market closes on February 12, management is expected to announce financial results for the final quarter of the 2023 fiscal year. Management had previously forecasted revenue for that quarter of between $1.50 billion and $1.55 billion. At the midpoint, this would translate to a 19.6% surge over the $1.28 billion generated one year earlier. It’s worth noting that analysts are particularly bullish. They anticipate revenue coming in near the high end of that range, with expectations of $1.54 billion in all. That would translate to a 20.7% rise year over year.
On the bottom line, expansion is expected as well. Earnings per share have been forecasted to be $1.53, which would be comfortably above the $1.35 reported for the final quarter of 2022. That would take net profits up from $427.1 million to $486 million. Adjusted earnings per share of $1.71 should beat out the $1.41 reported in the final quarter of 2022. That would translate to an increase from $445.1 million to $543.1 million. Management has not provided much in the way of guidance when it comes to profitability. The only substantive thing that they said is that the non-GAAP operating margin for the company should be around 42%. That would be only marginally lower than the 42.6% reported last year. If we take the midpoint for guidance here and assume that the bottom line profit margin for the company will hold true, then we would be looking at about $510.6 million in net income, or $1.61 per share in profits on an adjusted basis.
Other profitability metrics should also be paid attention to when management reports. While net income is important, I would argue that cash flows are more important. In the final quarter of 2022, operating cash flow is only $40.5 million. But if we adjust for changes in working capital, we get a major increase to $909 million. And of course, we also need to be cognizant of EBITDA. For context, it totaled $486.5 million during the final quarter of 2022.
If we assume that analysts are right when it comes to earnings, then the company’s overall profits for 2023 should be around $1.96 billion. Annualizing the rest of the financial figures for 2023 would imply adjusted operating cash flow of $2.13 billion and EBITDA of $2.41 billion. Taking these figures, we can then value the company as shown in the chart above. As a value investor, these are very difficult numbers to swallow, even though the 2023 forecast is well below what the 2022 data shows. But the next thing that caught my eye, besides how lofty the stock is, was the fact that there was a massive decline in valuation from 2022 to 2023. This denotes rapid bottom line expansion, which we have already seen earlier in the article. So I decided to run a hypothetical analysis using updated pricing for the company and these updated cash flow and profit estimates.
In the table above, you can see a scenario where we project our profits and cash flows for the company for the 2024 through 2027 fiscal years and where we simultaneously look at how expensive the stock is under these scenarios. The growth in these profit figures is assumed to be 20% per annum, which does not seem unrealistic given the company’s recent financial results. And in the table below, you can see the same thing but using a 30% annualized growth rate assumption. In both cases, the stock does get significantly cheaper, really starting around 2025. But by 2027, shares don’t look bad at all. In fact, if growth is at the high end of this range, the stock might even be undervalued at that point.
Takeaway
Heading into earnings, investors are going to want to pay attention not only to the data provided by management, but also to any indication of what the future might hold for the firm. Management has done a great job up to this point, but it’s difficult to continue growing an $85.8 billion firm, as measured by market capitalization, at a rapid rate. In truth, shares are getting pricey, and it might not be too long before a downgrade is justified. But if growth can continue as it has been for the foreseeable future, I would say it’s a bit premature to flip that switch just yet. So for now, I’m keeping the company rated a soft ‘buy’. But that picture could change depending on what results come out.
Arista Networks, a Silicon Valley-based technology company, has garnered a lot of attention in recent years for its impressive growth and dominance in the networking industry. With their stock (NYSE:ANET) reaching all-time highs, many investors are left wondering if the company is overpriced. In this article, we will take a closer look at Arista Network’s latest earnings report and evaluate whether the company’s stock is truly overvalued or not.
Understanding Arista Networks’ Business Model
Before we dive into their financials, it is essential to understand what Arista Networks does and how they generate revenue. Arista specializes in developing and selling cloud networking solutions, including switches, routers, and software-defined networking (SDN) products. Their target market is large data centers and cloud service providers, making them a key player in the fast-growing cloud computing industry.
Arista Networks’ Earnings Report Overview
Arista Networks recently released its third-quarter earnings report for 2021, and the results were impressive. The company reported revenues of $828.4 million, a 28.9% increase from the same period last year. Their net income also grew by a staggering 79% to $217.3 million, and their gross margin increased to a record-high of 66.7%.
Moreover, Arista Networks beat market expectations for both revenue and earnings per share (EPS). The consensus estimate for EPS was $3.25, and the company reported $3.77, marking an earnings surprise of 16%. These strong financial results have undoubtedly contributed to the company’s stock reaching all-time highs.
Is Arista Networks Overpriced?
Given Arista’s impressive financial performance, it is worth evaluating if their stock is overpriced. To determine this, we will analyze their current valuation, growth potential, and competitive landscape.
Valuation
Currently, Arista Networks’ stock is trading at a price-to-earnings (P/E) ratio of 33, which is relatively high compared to the industry average of 22. This suggests that the company’s stock may be overvalued. However, it is crucial to consider that Arista Networks’ valuation has been even higher in the past, with a P/E ratio of over 40 in 2019 and still managed to deliver strong returns for investors.
Growth Potential
Arista Networks has been consistently delivering strong growth, with a 5-year revenue CAGR of 23.2%. The company’s focus on cloud networking solutions positions them well in an industry that is expected to continue growing rapidly. As more businesses move towards the cloud, the demand for Arista’s products and services are likely to increase, leading to sustained growth in the coming years.
Competitive Landscape
Arista Networks’ closest competitor is Cisco (NASDAQ:CSCO), which has dominated the networking industry for years. While Cisco has a larger market share, Arista Networks’ recent growth has closed the gap significantly. Additionally, with the rise of cloud computing, Arista’s products are becoming more preferred among large data centers, putting them in a strong position to continue challenging Cisco’s dominance.
Benefits and Practical Tips for Interested Investors
For investors interested in Arista Networks, there are a few key points to keep in mind before making any investment decisions:
– Evaluate the company’s financial health and growth potential: As we have seen, Arista Networks has been delivering strong financial results and has a promising future. However, it is always essential to conduct thorough research and understand the risks before investing in any company.
– Monitor the competitive landscape closely: While Arista Networks’ products and services are highly sought after, there is intense competition in the networking industry. Keep a close eye on their competitors and how the industry evolves to get a better understanding of Arista’s growth potential.
– Diversify your portfolio: Investing in a single stock, regardless of how promising the company may be, can be risky. It is always wise to diversify your portfolio with a mix of industries and company sizes to minimize risk.
In Conclusion
Arista Networks has proven to be a strong contender in the networking industry with its impressive growth and strong financial performance. While their stock may seem overpriced compared to the industry average, the company’s growth potential, competitive advantage, and financial health suggest that their current valuation may be justified. As with any investment, it is essential to conduct thorough research and consult with a financial advisor before making any decisions.