Arista Networks: Adapting To Changing AI Infrastructure Demand (NYSE:ANET)

Investment Thesis

Arista Networks, Inc. (NYSE:ANET) guidance for the upcoming quarter doesn’t tally up with everything that investors are seeing in the sector right now. Presently, investors are seeing massive demand for AI infrastructure.

And what Arista points to for the quarter ahead are slowing revenue growth rates and lower gross margins.

That being said, I make the case that nuance is required here. Arista’s cloud titan customers are slowing down their capex after a very pronounced increase in spending last year. Consequently, it’s only normal for there to be some normalization in Arista’s growth rates.

Indeed, I argue that this story is far from over.

Why Arista? Why Now?

Arista Networks is a cloud networking solutions company. Arista sells high-performance network switches to hyperscalers cloud titans and cloud computing environments.

The business provides networking infrastructure support to the increasing demands of modern data centers including high-speed data transmission. Essentially, Arista Networks focuses on providing networking solutions tailored to the needs of large-scale data centers.

Here’s a quote from the earnings call echoing this strategy,

Arista’s data-driven AI clusters are optimizes network assurance for mission critical AI and ML workloads.

Using advanced features like microburst and fan in congestion management, ultra deep packet buffer memory with latency analyzer provides real time telemetry, visibility, automation, and dynamic controls for their AI and ML data centers all based on open standards Ethernet.

In plain English, Arista seeks to deliver a combination of high-speed data transmission with low latency through network automation. This sounds complicated but it’s essentially seeking to enhance networking infrastructure.

Here’s another quote from the Q1 earnings call that exemplifies this, Arista seeks to deliver ”the promise of low power and improved price performance for demanding AI workloads.”

Given the high need for AI infrastructure, why is the stock trading sideways?

Revenue Growth Rates Slow Down, So What’s Next?

Above we get to the heart of the matter. Arista was growing at more than 50% CAGR for several quarters.

Now it is guided to grow by around 30% CAGR. Clearly, management has left itself ample room to be conservative with this guidance, and its revenue growth rates could even end up around the mid-30s% CAGR in the upcoming quarter.

That being said, growing in the mid-30%s is not quite the same as growing at +50% CAGR.

Furthermore, the fact that these revenue growth rates so quickly decelerated, would have caused a lot of investors to quickly take profits and move on.

And this will reverberate lower down its income statement too.

Profitability Profile Slows Down

Case in point, here’s an excerpt from the earnings call that is weighing on the stock

[…] we expect some moderation in customer spending, especially with our cloud titan customers following year of accelerated demand in 2022.

More specifically, we can see that Arista is guiding for Q2 2023 to see non-GAAP gross profits of around 61%, which is down nearly 300 basis points from the same period a year ago at 63.9%.

Now, I believe that management is being conservative, and leaving itself room to positively impress investors when it ultimately reports its Q2 2023 results. Nevertheless, when taken at face value, not only is Arista’s revenue growth rate slowing down, but its underlying profitability is also moving in the wrong direction. And clearly, this isn’t congruent with the story that investors want to see.

Investors right now want to see rapidly increasing revenues and expanding margins as the need for high-quality, low latency, high-speed data transmission increases. And that doesn’t appear to be lining up with Arista’s next quarter’s guidance.

That being said, I believe it’s important to think about the overall context. Last year, cloud titan customers were pulling forward significant spending. It’s only logical that they moderate their spending and take some time to digest some of their investments. This doesn’t mean the story ends here for Arista, it’s more the case that there’s a bump in the road.

The Bottom Line

The bearish concern is that Arista Networks’ guidance for the upcoming quarter is not aligned with the current high demand for AI infrastructure in the market. More specifically, Arista is experiencing slowing revenue growth rates and lower gross margins.

Indeed, Arista’s cloud titan customers are reducing their spending after a significant increase in the previous year and are now normalizing their revenue growth rates.

All that being said, I argue that Arista Networks, Inc. is very well-positioned for high-demand low latency networking. Furthermore, I believe that paying around 28x forward EPS for Arista is a very fair price.