High-growth companies inevitably reach a point at which even growth rates that most would admit are strong simply aren't enough to satisfy profit-hungry investors. Arista Networks (NYSE:ANET) appears to be nearing that point, and even though its open-source tools for network development continue to see huge adoption rates among its clients, its shareholders have gotten used to a pattern of dramatic outperformance that simply can't last forever.
Coming into Thursday's fourth-quarter financial report, Arista shareholders had their typical high expectations for the company, and as usual, Arista beat them. Yet the stock-price movement that followed suggests that Arista didn't beat those expectations by quite as large a margin as they truly wanted to see. Let's take a closer look at Arista Networks and whether its results really give investors any reason for concern.
Arista stays on target
Arista Networks' fourth-quarter results continued its impressive run of growth. Revenue jumped 43% to $467.9 million, and that was slightly higher than the consensus forecast among investors for $463 million in sales. Adjusted net income soared 77% to $137.3 million, and the resulting adjusted earnings of $1.71 per share topped the $1.42 per share that most of those following the stock had expected to see.
Sales gains were well balanced across Arista's segments, with product sales jumping 41% even as the smaller but still important services division experienced stronger growth of more than 55%. Internal efficiency remained strong, with gross margin rising another 1.5 percentage points to 65.9%.
As we've seen before, Arista kept a tight rein on most of its expenses. Research and development costs jumped by half, but a decline in overhead expenses and just slight increases in sales and marketing costs helped keep operating expenses in line. That in turn helped to boost Arista's earnings by a greater percentage than its revenue gains.
CEO Jayshree Ullal was very happy with the way that the year ended. "2017 represents a market tipping point," Ullal said, "with Arista's disruptive software-driven architecture gaining mainstream acceptance as we surpassed 15 million cumulative ports of cloud networking." CFO Ita Brennan pointed to 2017's 46% revenue jump and 70% rise in adjusted earnings per share as further marks of success for the year.
Can Arista Networks keep moving higher?
Arista's future remains bright. One reason why Arista had such a strong year was that business from key customer Microsoft (NASDAQ:MSFT) grew even faster than the company had expected. Microsoft made up about 16% of Arista's business, and Ullal pointed both to Microsoft's own success with Azure and to Arista's Microsoft engineering team in developing use cases that appealed to users of the systems. Such collaborations with what the CEO called "cloud titans" will be a top priority in driving Arista's future growth.
2018 promises to be an interesting year for Arista. The company expects to enter into the 400 gigabit Ethernet market space in the coming year, and after having reached the status of market share leader in the 100 gigabit Ethernet switching industry, Arista can expect to lever its reputation among purchasers to work more closely with service providers, cloud specialty providers, and enterprise customers more broadly.
Arista's first-quarter guidance was generally in line with what investors had foreseen. A range of $450 million to $468 million in revenue was in line with the consensus forecast for $458 million, and guidance for adjusted gross margin of 63% to 65% and operating margin of 32% was generally consistent with past quarters.
Yet shareholders wanted more from Arista, perhaps through stronger projections for 2018 or further signs of accelerating growth in key product areas. In response to that disappointment, the stock dropped 13% in pre-market trading Friday following the Thursday afternoon announcement. In the long run, though, Arista Networks seems to be doing everything it can to capture a growing piece of the important networking space. Long-term investors might well see any pullback for the stock as a buying opportunity rather than a cause for concern.
Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Dan Caplinger has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Arista Networks. The Motley Fool has a disclosure policy.