The network vendor Arista Networks presents a rare characteristic among high-growth tech companies: It’s been posting significant profits over the last several years. The company took advantage of the shift from traditional locally hosted networks to cloud networks. But the company's expansion into other markets may drag its impressive performance.
A significant cost advantage
Arista's business consists of selling software and network hardware -- routers and switches -- that equip data centers. The company developed flexible solutions that address the superior customization and performance that cloud networks command compared to legacy networks.
As a result, and thanks to the growth of cloud computing, the company increased its trailing-12-month (TTM) revenue to $2.36 billion, from $71.7 million in 2010. With its growing scale, the company's revenue growth decelerated to 21.3% during the first half of the year compared to 30.7% and 45.8% in 2018 and 2017, respectively. But the company's strong double-digit revenue growth remains impressive.
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In contrast, Arista's competitor Cisco (CSCO 0.46%) posted mid-single-digit revenue growth over the last several quarters. And Juniper (JNPR 0.16%), another competitor, reported declining revenue. Cisco's and Juniper's broader portfolios, which include legacy network components, explain their relative underperformance compared to Arista.
Many other tech companies have been reporting revenue growth in the same range as Arista, though. But none of them matched Arista's 30%+ GAAP operating margin (see table below).
Arista's cost advantage is due to the large size of its customers. Management confirmed during its last earning call cloud titans -- giant cloud companies -- constituted the company's largest segment. For instance, Microsoft represented 27% and 16% of Arista's revenue in 2018 and 2017, respectively. Besides, Arista also serves other huge companies such as service providers and financial institutions.
Since Arista is increasing its revenue primarily from its existing large customers, its sales and marketing expenses stay low at 8.6% of the company's revenue during the first half of this year. In contrast, many high-growth tech companies such as the ones listed in the table below need their sales and marketing expenses to exceed 44% of their revenue to acquire many smaller customers. As an illustration, Palo Alto's TTM revenue exceeds Arista's revenue by 22.9%, but Palo Alto's 60,000+ customers at the end of 2018 eclipse Arista's 5,500+ customers.
| Company | Revenue Growth YOY | Operating Margin | Sales and Marketing As a Percentage of Revenue |
|---|---|---|---|
| Arista Networks (ANET 0.19%) | 21.3% | 33.3% | 8.6% |
| Palo Alto Networks | 29.6% | (2.11%) | 46.5% |
| Fortinet | 18.3% | 12.7% | 44.5% |
| Splunk | 34.5% | (24.6%) | 61.4% |
Data source: Arista Networks, Palo Alto Networks, Fortinet, and Splunk, based on their respective current fiscal years. YOY = year over year.
Arista is expanding outside of its core business
Given its success in the cloud data centers, Arista is diversifying into other network areas. Management announced last year the company's expansion into the campus segment, which means the company's network solutions will also cover smaller local networks. And the company recently integrated wireless capabilities into its portfolio.
From an operational perspective, these decisions make sense. Cloud, campus, and wireless networks use similar technologies. Besides, customers may appreciate consolidated management systems, and Arista will profit from cross-selling opportunities.
But Arista must ramp up its sales and marketing efforts to reach a higher number of smaller customers in the campus segment. As a result, management indicated during its last earnings call the company's sales and marketing expenses would gradually increase to 10% of the company's revenue.
But Arista's forecasted sales and marketing costs seem still low compared to legacy network vendors. Cisco's and Juniper's sales and marketing expenses represented 18.4% and 21.7% of their respective revenue during their current fiscal year. As Arista is expanding into legacy network vendors' markets such as campus and wireless, Arista's sales and marketing expenses should increase and get closer to Cisco's and Juniper's costs over the long term.
No margin of safety
The market values Arista at trailing-12-month price-to-sales and P/E ratios of 7.4 and 26.5, respectively. These numbers indicate investors expect Arista to sustain its solid growth and its high operating margin. But given the potential decline of the company's operating margin because of its expansion outside of the cloud data centers, Arista's valuation doesn't offer any margin of safety.
Thus, despite Arista's impressive results, prudent investors should stay on the sidelines at the current share price of $229.1.
