Earnings Miss #1

This past earnings season we had two companies report with terrible results to the stock price. The first being Twitter and the second is Arista Networks. These are my notes from the Arista call along with our strategy going forward.

Notes from the conference call

Total revenues in Q3 were $654.4 million, up 16% year-over-year and above the midpoint of guidance of $647 million to $657 million. Service revenues remained strong, representing approximately 15.2% of revenue, down from 15.6% last quarter, reflecting typical seasonality of service renewals.

International revenues for the quarter came in at a $122.1 million or 19% of total revenue, down from 27% in the prior period. This volatility in geographical mix is largely driven by shifts towards U.S. deployments, in cloud titan business.

Overall gross margin in Q3 was 64.4%, above the midpoint of guidance of 62% to 65%, and down slightly from 64.7% last quarter.

Non-GAAP gross margins of 64.4%, influenced by solid performance from cloud titan and enterprise verticals.

Operating expenses for the quarter were $163 million or 24.9% of revenue, up slightly from last quarter at $158.7 million. R&D spending came in at a $.3 million or 16.1% of revenue, up from a $101.7 million last quarter. This reflected headcount growth and slightly higher levels of product-related NRE and prototype spending in the period.

Sales and marketing expense was $46.8 million or 7.1% of revenue, up from last quarter, with increased headcount somewhat offset by reductions in other sales costs.

G&A costs were consistent with last quarter at approximately $11 million, or 1.7% of revenue. Our operating income for the quarter was $258.2 million, or 39.4% of revenue.

This resulted in net income for the quarter of $217.1 million or 33.2% of revenue.

Diluted share number for the quarter was 80.75 million shares, resulting in a diluted earnings per share number for the quarter $2.69, up 27.5% from the prior year.

Cash, cash equivalents and investments ended the quarter at approximately $2.4 billion.

They repurchased a $115 million of common stock during the quarter, at a weighted average price of $224 per share.

Board of Directors has authorized a three-year $1 billion stock repurchase program commencing in Q2 ‘19. This program allows them to repurchase shares of common stock opportunistically and will be funded with operating cash flows.

Generated $269 million of cash from operations in the third quarter and a decrease from working capital requirements of approximately $25 million.

Registered a record number of new customers in Q3 and continue to drive new customer logo expansion at the rate of one to two per day throughout the quarter.

For calendar 2019, expect to have two customers that will be greater than 10% of revenue, Microsoft and Facebook.

In Q3, the international contribution was 19% with the Americas at 81%.

On Q4 2019 guidance, given the significant drop. After experiencing a pause of a specific cloud titan’s orders in Q2 2019, they were expecting a recovery in second half 2019 for cloud titan spend. However, they were recently informed of a shift in procurement strategy with a material reduction in demand from a second cloud titan, reducing their forecasts dramatically from original projections for both Q4 2019 and for calendar 2020.

They believe the cloud titan forecast should be modeled as flat to down in calendar 2020.

Saw strong recovery from the customer who had paused activity in the second quarter only to be surprised by a dramatic reduction in forecast for Q4 and 2020 from another key titan.

All indications are these actions are not affecting their position or market share at these customers but but an internal slowdown in spend for this specific client. (the client is managing their CapEx for networking and modulating the inventory and shifting to more of a just-in-time type forecast. So, typically, they provided two-quarter visibility, sometimes even three and four, and now, they're moving much more to a real time forecast at quarterly intervals. This particular cloud titan client is extending their server assets by more than a year. So, once the server assets get extended, that is significantly delaying the network spend too.)

Going to have tough comps going forward.

Guidance of the fourth quarter, which is based on non-GAAP results and excludes any non-cash stock-based compensation impacts and other non-recurring items is as follows: Revenues of approximately $540 million to $560 million; gross margin of approximately 63% to 65%; operating margin of approximately 36%. Our effective tax rate is expected to be approximately 20.5% with diluted shares of approximately 80.3 million.

The two reasons why business will slow down also in 2020, (1) because many of the cloud titan customers are extending their use of server assets and delaying the network purchase longer and buying other infrastructure or investing in other aspects. And (2) the 400-gig adoption. They had predicted initially that deployments could start as early as second half this year. They are shipping 400-gig products for initial trials this year, but the initial deployments have shifted by more than a year to second half 2020. Now they believe mainstream production will be 2021.

The change in customers extending their investments and the deployment of 400-gig is causing them to be more muted about 2020.

They are saying this decreased spend is specific to this client and is not a function of lost business to ANET, but rather deferred business. Cloud titans are delaying their spend or distributing their CapEx differently and ANET has a close partnership and relationship with cloud titans. And generally, especially in the case of Facebook and Microsoft, they’ve been not only a vendor customer relationship but really a co-development that requires the kind of partnership which is engineering to engineering, not just business. So, there is no evidence that competitively or white box wise, there has been any change. There has been process change. There is better inventory management, there is better procurement, optimization et cetera. And you can always expect these cloud customers want to be multi-sourced but it isn’t any different than we’ve seen in the past in behavior, relationship, in art, innovation. We have 10 400-gig products and a lot of them are in trials. So, relationship and the technology partnership couldn’t be better. They work very closely with these customers to a point that they’re working on the 2021 roadmap along with these customers right now, and quite well aware of the changes they are making to the architecture as well, and have very direct feedback from customers as well that there is no alternate that's displacing them. It’s simply that demand has gone down.

This is not their share going to someone else, the clients demand has reduced.

Microsoft just won the JEDI contract. The team worked very hard on federal certifications in partnership with MSFT. The first thing that happens with these large contracts is they get contested. So, while the award may be given, they think it will take 6 to 12 months to see a material benefit.

See 2020 move to 400-gig as a transition year with cloud titan in terms of high performance. The effects of this transition will be felt in 2021.

Valuation

Twelve-month forward earnings forecasts call for $9.09 per share or 14% above the trailing twelve-month figure. Earnings are expected to compound 18% annually for the next three to five years (28% a few months back). The stock is trading 21x forward earnings but has averaged 30x over the past three and five years. If the company can achieve EPS of $14 to $15 per share over the next three to five years, we are looking for an absolute return of +100% over this time frame or approximately 30% IRR. We currently own the stock at an average cost of $243, but in all honesty, we have traded around this position and have booked profits so the average cost is somewhat lower.

Given the concentration risk of its large customers and the lumpiness of the revenue and earnings, we’re not going to add more at this time but will be watching to see how client capex materializes. That said we are not sellers of the position because it seems this mishap is more a case of deferred business than lost business. There are also catalysts on the horizon that keep us interested i.e. 400-gig adoption and the MSFT award.

Joseph S. Kalinowski, CFA