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Arista Networks Releases Weak Guidance ... Again: Should Investors Worry?

By Herve Blandin – Feb 18, 2020 at 8:00AM

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Management expects revenue from the company's cloud business to decline in 2020.

After many years of strong double-digit revenue growth, Arista Networks(ANET 0.91%) year-over-year fourth-quarter revenue dropped by 7.2%. Management also anticipates the company's core cloud business to decline in a meaningful way in 2020. Given these worrying updates, does the networking specialist remain a highly profitable growth story over the long term? 

Increasing challenges in the cloud

Arista Networks' fourth-quarter revenue fell to $552.5 million because of the volatile demand of its giant cloud customers such as Microsoft and Facebook that still represented 23% and 16.6% of its 2019 revenue, respectively. And during the earnings call, management forecasted these challenges would continue in 2020, leading to a meaningful decline in revenue from the company's cloud business. 

In addition, given their increasing scale, tech giants should keep on posting diminishing revenue growth for their cloud segment over the long term.

Cloud Business Revenue Growth in 2019 (YOY) Revenue Growth in 2018 (YOY)
Microsoft's Azure  62% 76%
Amazon's AWS  37% 47%

Data Source: Microsoft, Amazon, and Facebook. YOY = year over year.

Besides, some other threats could further affect Arista Networks in a negative way. 

Amazon announced last quarter that it would extend the useful life of its servers from three years to four years, starting in 2020. The effect of this decision for Arista Networks remains uncertain, but it means Amazon would buy fewer new servers over time, which would reduce the need for extra updated networking devices to connect these new servers to the network. Other cloud vendors could follow Amazon's path and extend the lifetime of their servers too.

On top of that, the competition in the cloud network data center area is intensifying.

Cisco Systems announced a significant shift in its strategy in December: It now sells disaggregated software and hardware to adapt to cloud titans' and service providers' demands. The success of this initiative remains to be seen, but the tech giant's attempt to capture market share with these huge customers represents a threat for Arista Networks.

The network vendor Juniper Networks also seems to have overcome its challenges in its cloud business. It now proposes routers -- devices that connect networks together -- that better address cloud giants' requirements in terms of performance and scalability. After two years of decline, revenue from Juniper's cloud segment increased by 0.9% in 2019, with a strong acceleration to 17.8% during the last quarter.

Cloud on blurred computer data center background.

Image source: Getty Images.

Staying competitive in a growing market

Given the expected growth deceleration and intensifying competition in the cloud area, Arista Networks' high-growth days seem behind it. Yet the company should still profit from the shift to cloud computing and the increase in worldwide data traffic over the next several years. In addition, it's enhancing its portfolio. 

Last Friday, the company announced it acquired the cloud-based software-defined networks specialist Big Switch Networks to reinforce its analytics and monitoring capabilities. 

And after its acquisition of the wireless vendor Mojo Networks in 2018, Arista Networks expanded its portfolio to the campus networking area (smaller corporate networks). Yet it must still grow this small business -- $100 million of revenue in 2019 --  in a mature market  to become meaningful to the company's total revenue of $2.4 billion in 2019. But Arista Networks has shown its ability to thrive in competitive markets: It increased its market share in the high-speed data centers from 10% in 2015 to 18.8% during the first half of 2019.

Besides, the company remains highly profitable. Thanks to its concentrated cloud customers, its sales and marketing expenses still represented less than 10% of its revenue during the last quarter, which explains its high operating margin above 30%. And thanks to its impressive profitability, it accumulated $2.7 billion of cash and equivalent on its balance sheet.

ANET Sales and Marketing Expense (% of Quarterly Revenues) Chart

ANET Sales and Marketing Expense (% of Quarterly Revenues) data by YCharts

However, with an enterprise value-to-sales ratio of 6.4 and a forward P/E ratio of 21.7, Arista Networks' valuation already prices some growth over the long term. Thus, the margin of safety seems limited, and prudent investors should wait for the stock price to decrease or operational performance to improve before considering investing in this tech stock.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to its CEO, Mark Zuckerberg, is a member of The Motley Fool's board of directors. Herve Blandin owns shares of Cisco Systems. The Motley Fool owns shares of and recommends Amazon, Arista Networks, Facebook, and Microsoft and recommends the following options: long January 2021 $85 calls on Microsoft and short January 2021 $115 calls on Microsoft. The Motley Fool has a disclosure policy.

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