Arista Networks: A bet on hyperscale network expansion

Looking back at the market, we see a tendency for certain stocks to become overvalued, often driven by excessive optimism. This phenomenon is illustrated recently by the rise of artificial intelligence (AI), propelling major stock market indices to unprecedented heights. Market experts often remind us that AI is not just a passing fad fuelling a speculative bubble, but a long-term engine of growth. Yet some of the elements crucial to its development remain undervalued. This is an opportunity for us to talk about Arista Networks, which is emerging as a fast-growing major player whose importance to AI infrastructure deserves particular attention.

Arista Networks specializes in Ethernet network solutions, essential for data centers, cloud infrastructures and enterprise networks. From its headquarters in Silicon Valley, it has established itself in barely two decades as a key player in the field of network technologies and equipment. Its core expertise lies in the design and sale of high-performance modular Ethernet switches, designed for cloud infrastructures and large-scale data centers. These devices enable efficient management and routing of massive data volumes from one server to another, with peak performance and adaptability to large-scale networks.

In parallel, Arista offers software-as-a-service (SaaS) solutions, including EOS (Extensible Operating System), Cloud Vision and Etherlink. These software tools automate switch operations and provide real-time monitoring of network performance, preventing failures and congestion.

Demand for these technologies is growing rapidly, driven by the emergence of disruptive digital services such as decentralized finance, automated manufacturing processes and the growing need for high-speed communications networks. Arista is also playing a key role in addressing the challenges posed by generative AI and accelerated computing clusters, thanks to solutions that optimize execution speeds, coordinate workloads and regulate algorithm congestion through efficient prioritization.

The quiet strength of a linear compounder

The group generated nearly $5.86 billion in sales in 2023, with 86% of this coming from the sale of licensed software, subscriptions and network equipment (switches, routers, cables and optical solutions). Its main customers, operating in the finance, telecoms and technology sectors, manage major digital infrastructures. Among them, Microsoft and Meta top the list, benefiting from these giants' substantial investments in AI deployment.

The remaining revenues come from post-sales support contracts, including technical assistance and maintenance. Geographically, Arista mainly targets the US market, which accounts for 80% of its sales, followed by Europe (11%) and Asia-Pacific (9%).

The group has enjoyed a remarkable growth trajectory, multiplying its sales by 12 in the space of a decade. Post-COVID, the company has seen its revenues increase by almost a billion dollars a year. This growth is accompanied by exceptional profitability, with free cash flow of $2 billion, which doubled over the period, and net margins of 35% and operating margins of 45%, the highest in the sector!

What's more, Arista regularly exceeds market expectations with its quarterly earnings, posting an average surprise rate of 23% over the last eight publications. The company thus stands out in the hyperscale data center market, beating out historic leader Cisco Systems, which is showing gloomy prospects and stagnant growth.

In addition, strong demand for its products and recurring subscription revenues have enabled the company to generate a 36% return on equity, while maintaining one of the lowest levels of debt in the sector. With a leverage effect (net debt/FCF) of 1.5x, the company could pay off all its debts in less than two years without drawing on its reserves.

A multi-multi bagger

Since its IPO in 2014, Arista Networks shares have enjoyed dazzling growth, with an annualized growth rate of 150%, ranking it among the best-performing stocks in the S&P 500.

Performance over 5 years (Source: Zonebourse)

Market capitalization currently stands at around $120 billion. Analysts' recommendations are overwhelmingly positive, with 72% of them recommending buying or accumulating the stock.

Arista shares are trading at a projected PER of x48 for 2024, which exceeds the historical average of the last decade. This premium valuation, around 80% higher than that of the sector, is explained by unprecedented margins and the fact that Arista will overtake Cisco in terms of market share in 2023, becoming the sector's new number 1.

Market share in the high-speed data center switching sector (Arista vs. Cisco).

Source : Crehan Research Data Center Switch Market Share Report 4Q'23

This premium can also be explained by the company's advanced position in the AI segment, where valuations naturally tend to be higher.

A brief summary to conclude

Strengths :

• Very high margins and low debt.
• Majority consensus Buy.
• Demand for its high-speed, hyper-scale network solutions is growing strongly with the development of AI, and will continue to do so.
  Recurring subscription revenues.
• Proactive share buyback policy, with a USD 1 billion share buyback program launched in 2021 (share buyback of up to 10% of its initial cash position in 2023).

Weak points:

• Significant dependence on a few major customers, notably Microsoft and Meta, which account for 40% of sales.
• High valuation.
• No dividend payments.
• Sensitivity to fluctuations in adjacent markets, which could affect the company's performance in the event of an economic slowdown.