Top Cloud Stock Arista Networks Anticipates A Return to Growth

The last few years have been tough for Arista Networks (ANET 1.43%). Shares of the cloud and network infrastructure provider have barely budged since the start of 2018, hobbled by first a slowdown in its growth after years of disrupting the market share among the cloud titans, and then contraction in late 2019 and 2020.  

But as indicated by its third-quarter report, Arista's own recession is quickly coming to an end. This shareholder remains an optimistic buyer.

Lackluster numbers, but not for long

The company's third quarter wasn't particularly impressive compared to a year prior. Revenue was down by 7.5% year over year to $605 million, and adjusted net income fell by 11.5% to $192 million. Paired with the company's first-half results, this has most certainly been a forgettable run for Arista shareholders who had grown accustomed to it delivering double-digit percentage growth -- as it had done from the time it went public back in 2014 until 2020.  

Pp = percentage point. Data source: Arista Networks.  

But what was impressive was that Q3 revenue well exceeded the $590 million figure that was the top of management's guidance range. Even better, management anticipates returning to year-over-year growth in Q4: At the midpoint, its forecast for revenue in the range of $615 million to $635 million would amount to a 13% increase from the same period in 2019.

CEO Jayshree Ullal had this to say on the third-quarter earnings call:

Despite this tough reset year, we believe Arista will emerge stronger, not only returning to double-digit growth in 2021, but also aiming for consistent growth in the years beyond.

Image source: Getty Images.

What suddenly changed?

Ullal further explained that Arista management thinks a new multi-year growth cycle is underway. The cloud titans -- think Amazon and Microsoft -- will continue to be contributors to this story, though perhaps to a lesser degree than they were during the last decade now that the bulk of their massive data center infrastructure construction has been completed. But, in part because Arista has been continuously innovating and developing new tech, two new end-markets are emerging for the company: the campus cloud (smaller regional data centers for companies' internal use) and adjacent network routing; and network subscription software and services (which it has greater exposure to thanks to the acquisitions of Big Switch Networks and Awake Security earlier this year).  

As for the cloud titans, an eventual upgrade cycle on their part (driven by new 400G networking hardware) could be the key to sustained double-digit percentage expansion for Arista overall, but those upgrades haven't begun yet. But that's OK, because the largest cloud services providers -- once its primary customers -- now account for a far smaller percentage of Arista's sales than they did in the past. In Q3, Ullal said they provided 37% of revenue, but enterprise and financial firms were also at 37%, and smaller cloud service providers were at 26%.  

The campus cloud product portfolio specifically could provide some of the most dramatic upside for the company over the next few years. In its first year, the new segment hauled in $100 million in sales. Arista's top brass said it expects to double that annual rate by the end of 2021, and foresees it becoming a $500 million a year revenue generator further down the road. Given that the company booked $2.22 billion in sales over the last 12 months, that would be a significant addition to the overall business.  

Of course, Arista's outlook for 2021 is preliminary -- a lot could change. But the expected return of double-digit-percentage expansion is promising -- both for the top and bottom lines. And exiting September, Arista still had ample cash and short-term investments of $2.85 billion on hand and zero debt. Shares currently trade for 23 times trailing 12-month free cash flow, which could make them a real value if the cloud computing and network hardware firm does indeed return to growth mode next year.