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Next Wave Portfolio — New Addition: Arista Networks

The cloud megatrend is a significant positive force for Arista Networks (ANET), a pure-play high-speed datacenter switch vendor with a focus on software. Founded in 2004, the company shipped its first product in 2008. Since then, it has become a major disruptor in the switching market. I am adding Arista Networks to the Next Wave Portfolio based on the company’s solid growth profile (revenue this year is expected to be up 27%) and ability to continue to gain market share.

An intense battle is taking place in datacenter switching, the only part of the overall Ethernet switch market that’s showing any meaningful growth. There is a massive shift of capital expenditures to support infrastructure investments in the cloud. As more data and applications move to the cloud, more datacenters are required around the world, leading to increased demand for high-speed Gigabit Ethernet switches (10, 25, 40, 50 and 100 GbE), which can handle massive data flows in a highly reliable manner.

The overall switching market is worth about $22 billon, with datacenter switches representing roughly $7 billion (32% of the total) and older-technology Ethernet switches at $15 billion, according to Crehan Research and Dell’Oro Group. By 2019, it’s estimated that the datacenter switching segment will increase to $12 billion (49% of the total), while the standard Ethernet segment will decline to $12.5 billion. 

The always-on connectivity requirements of cloud environments give the high-speed switching market high barriers to entry. Switching veteran Cisco Systems (CSCO) controls about 61% of the market. While some older vendors are involved (including Juniper Networks and Brocade), Arista (estimated to have a 12% share) is the only major player showing significant growth. Arista’s revenue this year should easily top $1 billion. In 2015, Arista’s revenue rose 43% to $837.6 million.

The software focus at Arista is the one thing that really sets the company apart from other switching vendors. Fully 90% of Arista’s engineering resources are always at work trying to improve the company’s software stack. Based on pure Linux, Arista’s EOS operating system is totally open and programmable, two things required by Web 2.0 and cloud services customers. Competitors claim to have open systems, but they’re not as flexible. Arista’s offering is also highly reliable, boasting the only operating system that is “self-healing,” meaning quick recovery times following an outage.

In addition to Web and cloud customers, Arista targets the technology, financial services, media/entertainment, business services, education and government verticals. Arista has an installed base of more than 3,700 customers, up from around 1,000 in 2011. Last year, Arista added 700+ new accounts. The 10 largest customers represent roughly 43% of total revenue. The company has a long-standing strategic relationship with Microsoft, the only 10%+ customer. Microsoft in 2015 accounted for 12% of revenue, down from 15% in the previous year. As Arista’s customer base broadens, the Microsoft-related revenue concentration will continue to come down.

Arista deploys the land-&-expand sales model used by many tech companies. For new customers, it usually gets its foot in the door with an initial order that is concentrated on a particular segment, such as a Big Data cluster or traffic monitoring. Once Arista proves itself with a niche application, customers tend to order more switches for various purposes. Right now, there is heavy demand for 10 GbE ports, while demand is ramping for 25 and 40 GbE ports (at higher ASPs).

Since datacenter switch deals tend to be large and require attention to detail (some project build-outs take as long as two years), the company uses a direct sales approach, and then fulfills through resellers and partners. Arista has strong relationships with its key technology partners (VMware, F5 Networks, Palo Alto Networks and Splunk). For Palo Alto, Arista even reconfigured data flows to optimize bandwidth into the cybersecurity vendor’s next-generation firewalls.

On the competitive front, Cisco is always a formidable challenger, as it uses its vast resources, tight industry relationships and tough pricing tactics to its advantage. But in high-speed datacenter switches, Cisco lacks Arista’s software technology edge. Plus, Cisco forces customers to buy into its proprietary infrastructure framework for support, something that turns a lot of potential buyers off. A big positive: Large datacenter players usually deploy a dual-sourcing strategy, and these days they’re often selecting Arista in addition to Cisco.

It should come as no surprise that an intense rivalry has developed between Arista and Cisco. The networking giant especially does not like that Arista is run by Jayshree Ullal, former head of Cisco’s $10-billion datacenter networking unit. Cisco has filed two lawsuits against Arista, one pertaining to copyright infringement and the other involving a patent dispute covering software features and functionality. Cisco obviously believes it has legitimate claims, while Ullal has questioned the timing of the suits, coming just when Arista is putting up some big growth numbers as a public company. The ongoing litigation between the two companies is expected to drag on for some time.

Arista went public in June 2014 at $43 a share. Momentum investors took an immediate liking to the stock, driving it up to a post-IPO high of $94.84 in September 2014. Following the recent market correction (Arista shares last month fell to an all-time low of $52.51), the valuation has gotten more attractive, helped out by rising earnings estimates since the company in the middle of February reported better-than-expected results for the fourth quarter.

Revenue in the December quarter rose 41% to $245.4 million (above the consensus estimate of $241.1 million), while EPS of 80 cents topped the consensus by 19 cents. Operating margin expanded to 29.1% from 27.1% in the year-ago quarter. Deferred revenue of $196.8 million was up 85% year over year. For the first quarter, the company’s revenue guidance of $232 million to $240 million represents growth of 30% to 34%.

Over the past month, the 2016 consensus EPS estimate has advanced 14 cents to $2.76 (the Street-high estimate is $3.00). At a recent price of $58.37, the forward P/E is 21. The stock trades at 18.7 times the 2017 consensus EPS estimate of $3.12.

Arista Networks is a ‘Buy’ in the Next Wave Portfolio.

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