Arista (ANET 3.92%) develops and markets network hardware, such as switches and accompanying software used in data centers and cloud computing. The tech stock hit an all-time high of $325 in March 2019 but has since slid through a volatile year to $195. The bulk of the slide coincided with weaker-than-anticipated earnings reports.
The stock's valuation metrics also began looking much more attractive during this time frame, warranting further investigation by value investors.
Delivering superficially good results with a deteriorating outlook
Arista has high revenue concentration among its larger customers. Microsoft contributed to 27% of Arista's total sales last year, and more than 10% of total revenues came from Facebook.
High concentration customers can be problematic for any enterprise because a change in a single customer's behavior can drastically impact results. Some of that concentration risk has come to fruition in 2019. In its recent earnings call, management explained that two of its larger customers are scaling back network investment for the near term. As a result, Arista trimmed its Q4 revenue guidance to between $540 million and $560 million, which was $130 million short of analysts' forecasts. This change weighed heavily on its share price.
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Despite these headwinds, Arista still delivered revenue of $654 million for the third quarter, which represents 7.6% sequential growth and 16.2% expansion year-over-year. Its gross margin was relatively stable in the presence of top-line growth, allowing the company to improve an already-impressive net margin by 200 basis points to 32% in Q3.
These growth and profit successes illustrate overall healthy operating metrics. Arista has a 33.6% operating margin over the trailing 12 months, compared to 27.7% for its direct competitor Cisco (CSCO -0.52%), and 4% for the industry. This helps Arista drive an impressive 31.1% return on invested capital, which is 17.3 percentage points above the industry average. With a relatively debt-free capital structure and ample liquidity on its balance sheet, it would appear the company is efficiently run and financially healthy.
Aligning valuation with investment narrative is less straightforward
Arista was enjoying rapid growth amid an industry boom in recent years, delivering 37% three-year sales compound annual growth rate (CAGR). This rate was slowing coming into 2019, and the pullback in purchasing among large customers has seriously impacted Arista's growth. It's hard to look at these results — and management's recent remarks — and consider Arista a growth story in the medium term. This fact is part of what drove its stock price decline. There are other network hardware companies, such as Ubiquiti, with similar demand exposure but more bullish growth outlooks overall.
At the other end of the spectrum, Arista is not necessarily the greatest candidate for value investors or the risk-averse. Even though the stock has become less expensive based on its fundamentals, there are still cheaper alternatives with similar product demand exposure. Arista sports a 14.9 EV/EBITDA ratio, which is higher than Cisco's 12.1, HP Enterprise's 12.2, and the hardware industry's median of 10.2. Arista's 20.8 forward price-to-earnings ratio similarly exceeds Cisco's 13.8, HP Enterprise's 9.3, and the industry median 15.9. Its price-to-free cash flow at 17.6 echoes this trend as well.
Moreover, Arista does not pay a cash dividend, whereas Cisco shareholders enjoy a 3.05% dividend yield, and HP Enterprise pays 2.55%. Arista has higher growth potential than these peers, but they offer a more stable alternative for investors spooked by Arista's struggles.
Arista has become a sensible play in a growth industry now that share prices have adjusted and is attractive to hold as part of a bundle of stocks to gain exposure to macro trends driving data center and wireless network growth. However, it is difficult to show that Arista is the most compelling growth or value story among its peers.
The most convincing bull narrative would contend that the market is overreacting to temporary headwinds related to specific customers, and the continued proliferation of mobile devices and connectivity are bound to propel accelerated growth after the current challenges are annualized. If that were the case, and prior valuations resume along with growth rates, it could be a case where the market overreacted to temporary conditions.
