After several years of strong, double-digit revenue growth, Arista Networks (NYSE:ANET) posted a second consecutive quarter of revenue decline this week. And management forecasted a similar result next quarter. Yet the company remains a highly profitable network vendor that is exposed to the secular growth of cloud computing. Thus, at 31 times its anticipated full-year earnings, is Arista stock a buy?

Exposure to cloud data centers

Over the last decade, Arista has been developing a networking portfolio that filled the gap the dominating network giant Cisco Systems left after it failed to address cloud vendors' networking requirements.

In contrast with legacy, monolithic networking products that have been running enterprise networks since the previous century, Arista's solutions offer the scalability, performance, and flexibility cloud giants require to build and operate their huge networks.

Cloud on blur computer data center background.

Image source: Getty Images.

As a result, after several years of strong, double-digit revenue growth, the company's market share in the high-speed, data-center switching market increased from 3.5% in 2012 to 18% last year, according to the market research outfit Crehan Research.

However, the company's performance since the beginning of the year contrasts with that strong growth, which could worry shareholders. Second-quarter revenue dropped 11.1% year over year to $540.6 million. And management anticipates next-quarter revenue to decline by 11.4% compared to last year, based on the midpoint of guidance.

Granted, coronavirus-induced supply chain challenges had a negative impact on the company's results, but its exposure to a few huge customers also influenced its top line. During the last earnings call, CEO Jayshree Ullal indicated cloud titans (giant web-scale providers such as Microsoft and Facebook) represented approximately 40% of total revenue during Q2. 

Intensifying competitive landscape

Beyond these quarterly volatile results, Arista's long-term outlook seems challenging, too. With scale, sustaining strong, double-digit revenue growth will become increasingly difficult.

And the competitive landscape in Arista's core cloud data-center area is intensifying:

  • Cisco revealed last year a disaggregated software and hardware offering that better addresses the need of cloud customers.
  • After years of disappointing performance, the network specialist Juniper Networks seems to have successfully transitioned its cloud portfolio, as its cloud segment grew for five consecutive quarters.
  • The telecommunications vendor Nokia announced last month it would enter the data-center networking market with new software and hardware solutions. Given its existing relationships with telecommunication service providers, thanks to its 4G and 5G portfolio, Nokia could make a dent in Arista's business with this type of customer.

However, Arista's cloud business should remain relevant and strong over the long term.

For instance, the company announced during the last quarter a deeper integration of its networking portfolio with Microsoft's networking operating system SONiC. Given Microsoft's solid recent results with its cloud infrastructure Azure growing 50% year over year, that partnership represents a long-term tailwind for Arista.

More generally, the market research outfit Gartner ranked Arista as a leader in terms of ability to execute and completeness of vision in its magic quadrant for data-center and cloud networking. Similarly, another market research specialist, Forrester, placed Arista as a leader in its ranking system for "programmable switches for a business wide SDN", which is a relevant networking technology for cloud and enterprise data centers.

In addition, Arista is growing beyond its core cloud data-center area as it leveraged its cloud technology to offer solutions for smaller enterprise networks. Jayshree Ullal indicated the company reached its objective of accumulating $100 million of revenue by the end of June in its new campus (local enterprise data centers) business. She now expects that amount to double to $200 million in five to six quarters.

Fairly valued

As Arista addresses a few huge customers, its sales and marketing expenses as a percentage of revenue stay low (9.5% in Q2). As a result, the company's second-quarter non-GAAP (adjusted) operating margin of 38.1% remained elevated.

With enterprise value-to-sales and forward price-to-earnings (P/E) ratios of 7.3 and 31.1, respectively, Arista stock doesn't look cheap, though. But if the company overcomes its short-term, top-line decline thanks to the strength of its portfolio, the tech stock's valuation becomes reasonable.

However, the company must deliver flawless execution over the long term to offer its shareholders some upside potential. Given the intensifying competition, that remains a risky bet prudent investors should avoid.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.