1 Big Catalyst Is Driving Arista Networks Stock -- Is It Still a Buy?

There's a lot to like about Arista Networks (ANET 1.37%) right now. After a few years of slumber, the data center and networking equipment designer is in high-growth mode again. Second-quarter 2022 financials blew past estimates, driven by the company's innovation in data center solutions.

Of course, Arista is getting extra lift right now from a boom in data center construction. Old hardware is in need of a technological upgrade. Sooner or later, though, this upgrade cycle will lose steam. Is Arista stock still a buy right now?

Making hay while the sun's shining on data centers

The advent of cloud software powered by artificial intelligence (AI), increases in video content on the internet, and work-from-home have set off a boom in data center construction, especially in the U.S. Arista Network's "cloud titan" customers are particularly busy right now. Both Microsoft and Meta Platforms are expected to represent more than 10% of Arista's revenue this year.

To facilitate powerful AI software and increased traffic going into and out of data centers, companies like Microsoft and Meta are installing new networking equipment that can handle more data at faster speeds at these massive computing units for the cloud. The result has been booming sales for Arista -- and the first ever $1 billion-revenue quarter. This is in spite of its component suppliers not being able to keep up with the demand (thank the chip shortage for that). 

Pp = percentage points. YOY = Year over year. Data source: Arista Networks. 

Interestingly, Arista did see some pressure on pricing in the quarter because of inflation. Extra procurement and shipping costs also hurt, but management was still able to navigate these issues and realize some hefty operating profit margins. That speaks to the strength of the company's product portfolio, its trusted engineering team that assists customers with data center design and setup, and the bundled software that helps with ongoing network management. Because of this solid execution despite economic challenges, Arista management said it thinks the company is trending well above its previous outlook for 30% full-year 2022 revenue growth.

The top team is still taking things one quarter at a time, though, and didn't provide a specific full-year guidance upgrade. However, for Q3, revenue of $1.025 billion to $1.075 billion is expected -- representing a 40% increase over last year at the midpoint of the outlook. Adjusted operating margin should be about 39%, another strong showing in the face of supply chain problems.

A good deal for a cyclical stock?

Arista is clearly knocking it out of the park right now, and given delays in shipping parts, any missed deals this year could simply be pushed into 2023. In other words, Arista's strong run could have some legs for a while.

But here's the rub. Arista Networks isn't a chip and hardware manufacturer itself -- it leaves that work to third-party partners. But hardware sales are cyclical, even at the enterprise level. A strong run of sales growth can often be followed by a year or two of slowdown, or even a contraction. That's what happened in 2019 and 2020 during the last cyclical downturn in the semiconductor and tech hardware industry. A previous run higher in data center spending was followed by leaner times and lower profits. Eventually, this will happen again, but it's hard to say when. 

The question now is whether shares are a good deal given the present visibility we have on this growth cycle (another couple quarters of fast growth, but with increasing uncertainty in 2023). Arista Networks stock currently trades for 36 times trailing 12-month adjusted earnings per share. It's a premium-priced stock, but not totally unreasonable given the company's long-term growth (the cloud industry is expected to keep expanding through the end of the 2020s) and its deep relationship with data center owners and operators. It also has a rock-solid balance sheet with $2.9 billion in cash and short-term investments and zero debt.

Given the premium, I'd only buy in small batches over time to take advantage of inevitable dips and an eventual cyclical downturn. However, if you are looking for a long-term bet on data centers and the cloud, Arista Networks is a top stock to consider adding as part of a well-diversified portfolio.