Arista Networks(ANET -2.42%) disastrous guidance, which includes a significant drop in revenue, eclipsed the company's solid third-quarter results. Management indicated one giant cloud customer -- a cloud titan as Arista describes it -- caused the disappointing forecast, but the network vendor may face other important challenges over the next several quarters.

Strong third-quarter results and awful guidance

Third-quarter revenue of $654.4 million, up 16.2% year over year, exceeded the midpoint of the guidance range of $647 million to $657 million. Non-GAAP (adjusted) gross margin of 64.4% also reached the upper part of the guidance, and the 39.4% operating margin surpassed the 36% forecast.

Arista's third-quarter strong performance should have relieved investors since the company had reported underwhelming second-quarter earnings because of a pause in spending from Microsoft, its most important customer in terms of revenue. The recovery of Arista's cloud business and the strength of its enterprise vertical contributed to the solid third-quarter earnings.

Two blue clouds against a blurry computer data center background.

Image source: Getty Images.

However, guidance for the next quarter eclipsed these encouraging results given the significant magnitude of the forecasted revenue decline. In contrast with the company's strong double-digit revenue growth over the last several years, management expects year-over-year revenue to decline by 8% during the next quarter, based on the midpoint of the guidance range.

During the earnings call, the CEO Jayshree Ullal explained: "We were recently informed of a shift in procurement strategy with a material reduction in demand from a second cloud titan, reducing their forecast dramatically from original projections for both Q4 2019 and for calendar 2020." Further discussions with analysts revealed this specific cloud titan extended the lifetime of its servers, which reduces the need for Arista's network solutions to connect new servers to the network. This troubling shift also highlights the risks associated with Arista's concentrated business compared to many other tech stocks.

Significant cloud-related risks

Management's justification for the mediocre guidance points to an isolated issue with one customer. But other developments may impact Arista's business in the medium term.

First, the change in strategy from the cloud titan management mentioned earlier may not be limited to one customer, over time. The risk exists that other cloud titans will prolong the life of their servers as well. 

Second, the CEO discussed during the earnings call that tier 2 cloud providers -- smaller customers than cloud titans -- are reviewing their strategies too. The risk for Arista is these customers will decide to slow down their investments. They may also migrate their infrastructure to giant public cloud providers, which would increase Arista's concentration risks.

Third, the company delayed its initial 400G deployments into the second half of 2020, and mainstream 400G production would take place only in 2021. The 400G technology is important for performance-angry cloud providers since it boosts the amount of traffic their networks can handle by a factor of four compared to the currently available 100G technology. The magnitude of this issue will depend on the timing of Arista's competitors to deliver their 400G solutions at scale, though. 

For all network vendors, the lack of 400G optics -- small adapters that connect network devices to fiber -- causes the delays of 400G deployments. The network vendor Juniper hasn't gotten ahead of Arista since it announced the same timing for its initial 400G deployments. More importantly, the giant tech vendor Cisco may provide important information about the timing of its 400G planning during its next earnings call on Nov. 13. In contrast with Arista and thanks to its acquisitions, Cisco won't fully depend on third-party optics vendors. Arista risks losing market share in the high-speed datacenter market if Cisco announces the availability of its 400G solutions at scale before 2021.

Looking forward

With these negative developments, Arista's stock price dropped by about 24% after its earnings. Yet, given the risks, the trailing-12-month (TTM) P/E ratio of 19.5 remains elevated and investors should stay on the sidelines. In the short term, investors should make sure Arista is still on a par with its competitors to deliver its 400G solutions. And in the medium term, investors should focus on the health of the company's business with cloud titans.