Arista Networks Details Its Future Computing Needs and Efforts

Shares of Arista Networks (ANET -4.32%) are up 10% so far in 2019, but the ride getting there has been a wild one. The computer networking stock rocketed over 50% higher during the first quarter, rallying after an ugly end to 2018, but has declined since then as investors have come to terms with a slowing growth story.

A slowdown isn't bad news, though, as data center buildout and the global cloud computing movement it supports still have a lot of runway ahead. This looks like a buy-the-dip candidate to me after the most recent sell-off.

Q2 by the numbers

Arista's second-quarter revenue was up 17% year-over-year, a slow down from Q1 and the company's 26% annual advance but still a respectable number. Combined with higher margins from service revenue (made up of software and ongoing support for data centers) and new product rollouts like 400G networking equipment, adjusted earnings grew 26% in the second quarter.

Through the first half of 2019, Arista is putting up big sales numbers and realizing even greater profitability as it grows.

YOY = year over year. Pp = percentage point. Data source: Arista Network.

So why the recent stock capitulation? Investors seem to be worried that the slowdown in the second quarter will continue. CEO Jayshree Ullal said Arista added an average of one to two new customers a day during the second quarter, but those deals are clearly smaller than in times past. Even "cloud titans" like Amazon, Microsoft, and other tech giants are only seeing percentage growth in the single-digit realm. Speaking to that, CFO Ita Brennan made this comment on the earnings call:

As expected, we experienced some softness in demand from our cloud customers in the second quarter. While early indications are for improved demand from these customers in the September period, we believe that second-half growth in this business will remain somewhat muted as compared to prior years.

Campus networking, "edge" computing, and 400G to the rescue

Though massive new data center construction isn't going to be the boon it was in the past, there is still plenty of work to be done in developing the internet and the cloud-based computing movement it is supporting. According to Arista's big infrastructure equipment competitor Cisco (CSCO 0.44%), global internet traffic is expected to roughly double from today's traffic numbers by 2022, and the number of connected devices should exceed 28 billion (compared with 18 billion in 2017).

Image source: Getty Images.

That's where Arista and its peers come in. More infrastructure is needed to keep up with exploding demand, and though centralized data centers aren't booming anymore, smaller localized data centers (known as "edge" networking) and businesses' own on-campus data centers are still a fast-growing concern. To this end, Arista recently unveiled new products aimed at this emerging trend within the larger cloud computing evolution.

Campus data centers have a different set of requirements, meaning Arista will need to pursue new product innovation if it's going to continue acquiring new clients in this arena. But it's an evolution that Arista isn't completely unfamiliar with. Getting into the data center business in the first place was not an overnight success, after all. Speaking to that, Ullal said:

Step back for a moment and ask: When did we get our success in the data center with enterprise? It was five years after we started shipping products. We didn't even report much on the data center. We mostly focused on the niche of financials and the cloud in the early years, right? So I'm pretty sure we won't take five years to enter the campus market, but I'm here to say that the traction with enterprise really come in three categories: the early adopters, who already love our EOS, and therefore, that's going to be the fastest place of attraction; the CloudVision, don't underestimate that, where they're looking for that single point of management and single pane of glass; and then to your point, the third one will be new channels, new partners, new systems integrators. So if you look at those three segments, we can start playing in two out of the three already. And so my response would be that the campus technology in many ways is no different than the data center.

Ullal further explained that Arista is currently sowing the seeds for an eventual $500 million to $1 billion a year campus segment, but said it could take some time to get to that point. In the meantime, it could be slower going but don't dismiss new 400G technology. It only just started shipping this year, but the faster networking hardware could be a key driver in bridging the gap as existing data centers start upgrading to start taking on heavier traffic and computing needs.

In short, Arista Networks' near-term outlook is calling for a slowdown, but that should in no way dampen the longer-term potential of this company. After selling off sharply from its all-time highs earlier this year, now's a good time to put the stock on your watch list.