Is Arista Networks a Buy?

Shares of cloud network builder Arista Networks (ANET 0.01%) are down more than 20% from their all-time highs reached earlier in 2018. What may be confounding investors is that, in the trailing 12 months, the company has continued to post double-digit top- and bottom-line growth. Despite the stock and profits headed in opposite directions, though, Arista is still priced at a premium, with trailing-12-month price to earnings sitting at 80, and one-year forward price to earnings at 26.

That implies expectations that this cloud network company will continue to grow at a torrid pace. With organizations still making the transition from legacy technology to new cloud-based operations -- not to mention the world's insatiable desire for faster internet -- Arista's stock is worth consideration.

What happened in 2018 so far

Sales of Arista's networking hardware and services have both been on the rise in 2018, continuing the fast rate of expansion it's been on for years. While the company walks off a big legal settlement charge of $405 million that it took over the summer to settle an intellectual property dispute with Cisco, backing that expense out shows that the bottom line is increasing at an even faster rate. That's just the type of performance shareholders need to see from a fast-growing tech company that still hasn't reached scale.

Data source: Arista Networks quarterly earnings. YOY = year over year. 

Product sales bring good news, indicating that there is still healthy demand from organizations building data centers both off- and on-campus to meet their future computing needs. Gross profit margin from that segment sits at 61.4%.

Even better news, though, came from the service revenue segment. Though it's by far the smaller of the two reported businesses, gross profit margin on services was a much higher 81.2% through the first nine months of 2018. As Arista helps more organizations build out data centers, more highly profitable services are sure to follow.

Campus cloud and bandwidth

Despite the company's strong performance this year, Arista's pricey valuation relies on this trend continuing. There's competition, though, from Cisco -- the biggest networker in the business -- not to mention other smaller peers. The main drivers for Arista and friends have been big tech enterprises building out cloud-computing platforms and, more recently, on-campus clouds (data centers built on premises) needed by organizations that are migrating their operations onto their own data centers. But can that rate of demand continue?

Image source: Getty Images.

Arista thinks so, as there is plenty more work to do in the cloud. To maintain its pace, Arista recently went on its first-ever acquisition spree, purchasing Mojo Networks and Metamako. The former is a provider of cloud-based WiFi for organizations that eliminates the need for traditional hardware. Metamako makes hardware and software for low-latency networking, reducing the amount of time it takes data to travel between two points.

Increasing the speed and lowering the latency of networking have been key areas of focus given that faster cloud services and internet are in high demand among businesses and consumers alike. Metamako will help, but Arista has also been developing new 400 gigabit ethernet switches for next-gen data centers.

The ability for organizations to upgrade existing data centers and build new ones with higher capacity via 400G could be the next catalyst for the cloud industry. The company says it expects to start shipping its new tech and supporting software in the second half of 2019. In the meantime, Arista says upgrades and new build-outs won't be put on hold. That's because many data centers are still undergoing upgrades from previous generations of networking tech. That pace is expected to keep accelerating next year, so 400G could be icing on the cake if shipments start rolling a year from now.

That all adds up to some long-term business and technology trends that could help Arista expand at its current double-digit pace for years to come. A note of caution, though, is the previously mentioned forward price to earnings of 26. Paying for several decades of profits is a rich valuation that is only justifiable if Arista can maintain its momentum. That means bumps in the quarterly reporting road could lead to some wild share prices.

Investors who believe cloud computing and services have a long runway should give Arista Networks some serious thought. Just keep the initial buy small, and be ready to add to it on the inevitable dips (like the ones seen this year).