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What Are Arista Investors Really Scared Of?

By Dan Caplinger – May 3, 2018 at 7:43PM

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Once again, what seemed to be good quarterly results got a cold reception from shareholders.

There's no question that Arista Networks (ANET -1.62%) has tapped into an important part of the technology sector. The need to provide an open-source alternative to conventional network-development tools has provided the company with a devoted, loyal, and fast-growing customer base. Over the years, Arista has done a good job of bringing clients on board and then gradually getting them to build on their existing slate of services. Yet despite that success, fears about slowing growth rates have led Arista shares to fall, sometimes even after what appeared to be solid quarterly performances.

Coming into Thursday's first-quarter financial report, Arista shareholders expected extremely strong growth for the network-tool provider. As we've seen before, Arista's results were strong, but seemed to be not quite strong enough, and the stock fell sharply in response. Whether the stock bounces back as quickly as it did last quarter remains to be seen, but it's important not to take today's swoon as an isolated event, as it seems to reflect something that continually scares investors: the eventual slowing of Arista's growth rates.

Networking switches in a rack with neatly organized blue networking cable plugged in.

Image source: Getty Images.

How Arista fared

Arista Networks' first-quarter results remained extremely healthy, although those who aren't as optimistic about the stock will note that not all of its growth rates were able to move higher. Revenue grew 41%, to $472.5 million, outpacing the 38% growth rate that most of those following the stock were expecting to see, but slowing from its 43% pace in the fourth quarter of 2017. However, adjusted net income skyrocketed 87%, to $134.1 million, outdoing its 77% growth rate last quarter. Adjusted earnings of $1.66 per share far exceeded the $1.51-per-share consensus forecast among those following the stock.

Arista's segment results gave investors most of what they wanted to see and were well-balanced. Product sales were up 40%, while revenue from services was higher by 47%. Gross margin inched higher, to 64.1%, compared to year-ago numbers, although the figure deteriorated by more than 1 1/2 percentage points from where it was three months ago.

A look at Arista's expenses shows even tighter cost controls than we've seen in past quarters. Research and development expenses were higher by 25%, but sales and marketing expenses were up at a slower pace in the mid-teens. Overhead expenses actually fell by double-digit percentages during the quarter, reflecting the true success of Arista's efforts.

CEO Jayshree Ullal's comments showed just how well Arista did: "As we kick of 2018, I am pleased with our performance this quarter. We continue to experience meaningful relevance and expansion as customers shift to cloud networking."

CFO Ita Brennan also noted how strong fundamental performance showed up clearly in revenue and earnings growth on the financial statements.

What's next for Arista Networks?

Part of what will drive Arista forward is its capacity to generate new product lines and enhancements. The company said that it plans to release an expanded family of platforms to enhance switching and routing performance, with systems that can take advantage of the move to 25G and 100G capability and add features that will make it even easier for cloud-computing and enterprise clients to migrate networks toward the enhanced service. Serving clients throughout upgrade cycles is a key part of Arista's long-term strategy, which emphasizes retention and cross-selling of additional services over time.

Yet part of what might have stoked fear among Arista investors was the company's second-quarter guidance. The company set a range of $500 million to $514 million for revenue for the quarter, with adjusted gross margin of 62% to 64% and adjusted operating margin of 32% to 34%. Those figures are in line with the consensus forecast among those following the stock, and the margin figures didn't change much from what the company has projected previously.

Still, some shareholders seemed to forget that Arista has done a good job of topping its guidance, and the stock therefore dropped almost 9% in after-hours trading following the announcement. Those skeptics might be scared of slowing growth rates, but long-term investors understand that fears about a slowdown have been in the works for a long time. There's little to suggest that Arista can't keep defying the skeptics to produce above-expected growth in the months and years to come.

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.

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