Arista Networks' (ANET 0.66%) earnings report last week indicated the company closed 2019 the way management foretold it would, and it reiterated more of the same is ahead for 2020: a slowdown in big data center spending, creating short-term uncertainty, and a possible first-ever annual sales decline for the company.
Shareholders of the networking hardware outfit have been put into into unfamiliar territory. That kind of uncertainty isn't comfortable, and it would have been nice to hear some more warm-and-fuzzy outlook comments at the start of the new decade. However, such situations potentially spell opportunity for growth companies with strong secular tailwinds blowing at their back.
Charting unfamiliar and uncomfortable territory
Fourth-quarter 2019 revenue declined 7% year-over-year to $552.5 million, 19% of which was made up of service and software revenue compared with 15.5% a year ago. Adjusted gross margins increased to 65.2% from 64.1% in Q4 2018. Arista was a manic ride for the year, with lumpy sales causing plenty of ups and downs and cloud infrastructure, in general, slowed down. For example, its largest customers Microsoft and Facebook -- 23% and 16.6% of total Q4 revenue, respectively -- adjusted their buying activity for data center construction over the course of the year. Even still, shares rallied strongly from lows as Arista still posted a 12% revenue increase for the full-year period and adjusted gross margins came in at 64.7% versus 64.4% for 2018.
The drama isn't over heading into 2020, as Arista continues to adjust to the cloud computing titans slowing their construction activity and 400G technology deployment getting pushed out to next year. Management said it wasn't in a position to provide guidance for full-year 2020 but expects its biggest cloud customer sales to be flat at best. That contrasts with makers of other hardware like memory chips, which are forecasting a return to growth this year. Arista explained that the reason for this is that networking hardware sales patterns tends to lag behind memory chips. At any rate, Q1 2020 sales were projected to be $522 million to $532 million -- a year-over-year decrease of 11% at the midpoint -- and gross profit margins were forecast to be in line with 2019 levels.
The upshot for Arista
Nevertheless, Arista is still a long-term growth story. The company entered the on-campus networking hardware industry in 2019 and is currently running at about $100 million a year in revenue from that small segment, which was traditionally dominated by players like Cisco and HP. CEO Jayshree Ullal maintained during the last conference call that the first order of business was to begin conversations with these smaller network and data center customers. Now Arista is looking to scale that business into a $200 million segment, and then double again to $400 million in the next few years. Ullal pegged the total addressable market for these smaller networks at $10 billion, so the company is already making decent headway as a disruptor.
Arista's handful of acquisitions over the past few years are helping bolster its optimism, but it will likely be a while before on-premises data centers and networks will start seriously offsetting weakness in Arista's core cloud business. In the meantime, though, even flat or falling sales don't mean earnings will always be in reverse. Case in point: Even though Q4 sales fell 7%, adjusted earnings per share still eked out a 1.8% gain (and were up 22% for full-year 2019). Improving profit margins were key, as was Arista's stock repurchase program that lowered the number of shares outstanding.
A $1 billion buyback plan remains in force for the next three years, a significant amount considering Arista's market cap is currently just $17.3 billion. With adjusted net income margins running at nearly 33% last year, that leaves plenty of room for Arista to keep investing in new cloud and networking products and services, all the while starting to return excess cash to shareholders.
Plus, it's not like internet traffic and the need for new infrastructure are shrinking. On the contrary, it's still growing double-digits and expected to do so for the foreseeable future. Demand, and who's creating that demand, is just taking a breather and shifting hands, and Arista is adjusting accordingly. After two years of volatility, the stock has gone from high-flying and premium-priced growth stock to something trading at far more reasonable value: 19.3 times trailing 12-month free cash flow generation and 22.3 times one-year forward expected earnings. The bumpy ride looks like it could continue, but I haven't changed my mind about Arista Networks stock after the final report card of 2019.