Data center engineering specialist Arista Networks (ANET -1.98%) had an epic 2022. After early pandemic supply chain constraints that kept a lid on equipment it could ship to customers began to ease, it was off to the races. Companies are migrating their IT infrastructure to the cloud en masse, and Arista is increasingly being turned to as a trusted engineering and parts design partner.
But a new era is just beginning to dawn: AI. Microsoft (MSFT 0.11%) is a top Arista Networks customer, and its recent investment in ChatGPT parent OpenAI could set off a new spate of growth for data centers in the coming years. Same goes for Meta (META -0.05%) and its new plans for its AI infrastructure. Arista's 2023 outlook had puts and takes, but the stock could still be a buy for investors with a long-term outlook.
Cloud titans propel revenue higher in 2022 and 2023
Arista reported full-year 2022 revenue of $4.38 billion, a nearly 49% increase from 2021. Q4 2022 sales specifically notched a 55% year-over-year increase as cloud titans (big tech companies that operate their own data centers for the public cloud and for their own private use) spent heavily in the last year.
Cloud titans went from roughly one-third of revenue in 2021 to 46% of revenue in 2022. Meta and Microsoft in particular were top customers. CEO Jayshree Ullal said on the earnings call that sales from Meta accounted for 25.5% of Arista's revenue, and Microsoft was 16%. This massive increase from cloud titans should moderate in 2023, but will continue. Conversations with other cloud titans (like Amazon (NASDAQ: AMZN) AWS and Alphabet's (NASDAQ: GOOGL)(NASDAQ: GOOG) Google) could also yield further upside for Arista as well in the coming year.
This boon in business is the result of years of cloud and high-performance computing infrastructure development at Arista. However, with the global economy grinding to a halt as of late and worry of a recession in 2023, even money-saving cloud initiatives are starting to slow.
But all of a sudden, AI is making a splash. Microsoft made a $10 billion bet on OpenAI. Meta said it will be revamping its data center architecture to handle the increased use of AI workloads in the coming years too (yes, Meta is far more than a social media company, they also do some impressive behind-the-scenes infrastructure engineering as well). It's early days for this new big tech arms race, and it's unknown how big the AI industry will become. But one thing's for sure, AI will be a significant part of the tech world's development, and will expand on the use of data centers beyond how they currently support the cloud. Ullal briefly explained on the earnings call:
We see AI as a very, very important use case and workload for all our Cloud Titan customers. Clearly, it's in the first innings. We're just beginning. So very much like cloud networking 10 years ago, we see AI as an additional use case. It is a very, very small portion of our use cases so far. So a lot of upside ahead.
A lot more profit on the way?
Arista Networks could be a best-buy stock to bet on this future development of AI and related new data center use cases. Arista has said it expects revenue growth to continue in 2023. Guidance calls for about a 25% year-over-year increase on top of the 49% growth in 2022 -- with Q1 marking the fastest pace of expansion before growth rates begin to moderate the rest of the year.
But even better, Arista sees its profit margins rallying. You see, component shortages and other supply chain issues put a damper on Arista's margins over the last couple of years. However, as component shortages begin to ease later in 2023, management sees gross margins making a comeback -- which should in turn boost operating margins as well. It may not look like much, but a point or two of improving gross margin can do wonders for bottom-line profitability.
Data by YCharts.
Additionally, Arista is embarking on what it's calling its Arista 2.0 journey, where it builds on its best-in-class data center equipment business and begins focusing on full-fledged platforms. This includes bringing more software solutions to the table to support its customers' needs. Whenever software is brought into the mix, it can mean even higher profit margins and a sticky business relationship that results in more consistent financial results.
Arista is well-positioned to deliver as it builds on its success thus far. The company is highly profitable, and had $3.02 billion in cash and short-term investments and zero debt at the end of 2022. The big question now is how long will the data center boom last -- and how soon new AI use cases will begin to make a meaningful contribution to Arista's data center business.
Shares trade for 33 times trailing 12-month earnings, or 25 times one-year forward expected earnings. It's a premium price, even after a record-breaking year for Arista. Tread lightly with any purchasing right now, but if you believe data centers and AI will continue to be a secular growth trend for the rest of the 2020s, keep a close eye on this top tech stock.
