Shares of top data center company Arista Networks (ANET 0.94%) tanked on great financial results in the first quarter of 2023. As a new era of computing gets underway, led by generative AI services like ChatGPT, it seems investors had even higher hopes for Arista Networks than what it could realistically deliver.
This has nonetheless been a fantastic long-term growth stock, up nearly 900% since its IPO in 2014, and Arista management still anticipates strong growth this year. Is it time to buy the dip?
Worry over the cloud titans casts a long shadow
First, as far as Q1 headline numbers go, revenue was up 54% year over year to $1.35 billion, and adjusted operating profit margin was a stellar 41.2% -- both metrics above management's guidance provided a few months ago.
The outlook for the second quarter of 2023 and the balance of the year was also pretty good. Q2 revenue is expected to be in the range of $1.35 billion to $1.4 billion, implying growth of 31% from a year ago at the midpoint. Adjusted gross margin and adjusted operating margin should be 61% and 40%, respectively. Full-year revenue is expected to be about $5.5 billion, or growth of about 26%, just slightly better than prior commentary from the management team. Gross margin on data center products is expected to steadily rise throughout this year as Arista works through the remaining supply chain constraints it has been dealing with since the pandemic started.
Overall, with nothing seemingly changed from a few months ago, why did the stock price fall some 20% after the release?
It seems the market took out its magnifying glass and focused on Arista's "cloud titan" customers. Specifically, that means Microsoft and Meta Platforms, longtime users of Arista's network switching hardware and data center engineering specialists. After triple-digit percentage growth from these cloud titans in 2022, that expansion is now moderating -- thus leading to a slower pace of revenue growth for the balance of 2023.
Growth is growth, though, so why did investors panic? Well, after over two years of elevated demand due to a big backlog of business (thanks to the chip shortage), Arista is reverting to historical norms. That means lumpier order activity and less visibility on long-term demand trends. By 2024, that could mean a less certain annual growth outlook, but instead just quarterly guidance from Arista's management team.
A top play on the era of AI
The good news is that less visibility into the future certainly didn't detract from Arista's stock performance over the last decade, so as long as the growth story continues, this investment will be just fine. Additionally, as the new era of AI takes over, there should be no shortage of opportunities for Arista.
Companies including Microsoft and Meta are buying lots of computing accelerators from Nvidia, and connecting those accelerators together with networking chips from Broadcom. But to piece those parts together, Arista is becoming an increasingly important engineering partner. In addition to providing basic networking gear (think of it like the highways that data travels across), Arista also has an important portfolio of software to aid in the management and security of these data centers.
And with AI services like ChatGPT in the early innings of getting created and deployed in the data centers that power the cloud, Arista should remain a long-term growth play. The company's management reiterated it sees its addressable market steadily growing from AI, but it's currently unclear just how big that market will eventually become.
Thus, I'd say investing in Arista will require a bit of faith that data centers will continue to grow in importance. And at about 23 times expected 2023 earnings per share, this isn't exactly a value stock. Nevertheless, Arista Networks is still a small fish in a very large pond, its data center tech remains in high demand, and a highly profitable business model flush with cash ($3.33 billion in cash and short-term investments, zero debt) supports ongoing cash return to shareholders via stock buybacks.
If you were waiting for a significant dip before buying Arista Networks stock (or perhaps buying more of it), this looks like a great buying opportunity to me.
