arista networks nyse: anet recommendation: buy · q1 '17 q2 '17 q3 '17 q4 '17...

Arista Networks

NYSE: ANET

Recommendation: BUY

Alex Tullman & Connor O’Brien

Investment ThesisRecommendation:

Arista Networks is (NYSE: ANET) is a great high growth stock as it holds a position as the high-end provider and lead innovator in a rapidly growing industry, while currently being underpriced because of a market overreaction.

Rationale:

The current price of $193.68 provides a cheap entry into a company on the supplier side of one of the fastest growing sectors in tech. As a recognized high-end supplier, Arista Network will continue to succeed as long as cloud network services are demanded.

2

1. Strong tailwinds and growth potential in the cloud network industry

2. Arista Network is known as the high-end provider for specialized cloud network hardware and software

3. Recent 25% drop in share price is an overreaction that has left the stock undervalued

Price Target: $230.7319.17% upside to current price of $193.68

Company Overview

3

Overview Management

Revenue Segmentation

• Arista Networks, Inc. develops, markets, and sells, cloud

networking solutions in the U.S. and internationally

• Solutions consist of extensible operating systems, a set of network

applications, and gigabit Ethernet switching and routing

platforms – focus is on ethernet switches

• Contracts with Jabil Circuit, Sanmina Corp., and Foxconn to

make its switches

• Has approximately 5,500 end customers worldwide in

approximately 86 countries.

• President and CEO (2008-Present)

• Jayshree – left 15-year career with Cisco to be CEO

• Chief Development Officer and Chairman (2004-Present)

• Bechtolsheim – gigabit startup acquired by Cisco, VP of

Gigabit Systems Business at Cisco

• Founded Arista Network in 2004 to create a company

more specialized in gigabit ethernet switches

• OG investor in google, founder of Sun Microsystems

• Chief Technology Officer and Senior VP (2004-Present)

• Duda – pioneer in networking software, architect of EOS

• Cisco design head on software after Granite acquisition

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Service

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The Cloud

User has access to data stored in remote server

warehouses

Work and data is stored in remote server

warehouses rather than the computer’s

hardware

When requested, the data is sent to the user’s computer

utilizing switches

All work is done on the personal computer,

but is then sent to the servers and stored

remotely

Rather than everyone needing sufficient

hardware to store data, this process is “outsourced”

Requests for data

Delivery of data

Importance:Saves costs and increases efficiency by leveraging the infrastructure of large data storage firms. Computers become access points to a “cloud” of remotely stored information. “Sharing the same Netflix account,” or specialization

1. Strong Cloud Industry Outlook

5

Cloud Services Public Spending Growing % of Data Center Revenues

Key Industry Drivers High-End Customers

Cloud services are becoming more mainstream• Apple, Google →Microsoft, Amazon, Verizon, Facebook, Dropbox

Demand for data to be shared rapidly and efficiently is increasing

Ability to store data in-house is less feasible due to the amount being transmitted and analyzed

In-house computing technology is expensive and not currently feasible for many firms

Software as a Service (SaaS), Infrastructure as a Service (IaaS), and Platform as a Service (PaaS) are three emerging industries that are currently maturing into definite sectors of the “Cloud” which is providing clarity in the market

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Together Microsoft and Facebook comprise roughly 10% of ANET’s annual revenue. This concentration can be concerning, but both customers are committed to working with ANET as they continue to develop their cloud networks. Both customers have deep pockets, are currently financially healthy, and should continue to be leaders in their respective industries.

2. Competitive Advantage

6

Leading Hardware Capabilities CloudVision

Arista’s Extensible Operating System (EOS)

• Market leading proprietary software that allows integration with third-party devices to achieve effective solutions in multi-vendor networks

• Arista has more than 10 million lines of code and 10,000 person-years of software engineering into EOS

• Open and Programmable

• Built on an Open Source Linux Kernel which allows for software to be highly modular

• Self healing and automotive capabilities

• Creates very limited downtime and troubleshooting

• EOS software runs across all of its products, increasing reliability, and decreasing complexity and cost to set-up and maintain network

• While Cloud titans have utilized EOS to develop their own automation and management tools, CloudVision provides an interface for proactive troubleshooting, performance monitoring, and compliance to all of Arista’s customers

• Arista sees CloudVision benefitting 3 major segments

• Cloud Titans – that prioritize scale and control

• Traditional Enterprises – that value turnkey solutions

• Long-term Cloud Enterprises – that rely on top of market solutions for a competitive advantage

• Market Leading merchant silicon

• Traditionally vendors have engineered processors that are task specific circuits (ASIC) and are coupled with task specific software leading to vendor lock-in and limiting customer choice

• Merchant silicon circuits are not task specific, but can be generally used across networking switches, which prevents such limitation

• Top of the Market Cooling and Energy Efficiency

• Important to maintain optimal functioning of major server warehouses

Networking Equipment - Switches Market

7

Global Ethernet Switch Market by Share

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Overview

• In a network, switches receive and send data from one end-point (usually a server) to another endpoint

• Many different types of switches based on layer, throughput, and networking abilities

• Networking ethernet switches be made for small business or campuses to the biggest cloud titans like Microsoft and Amazon

• Market contains both cloud and non-cloud capable ethernet switches

• Major cloud players: Cisco, Arista, and Juniper

Ethernet Switch by Throughput

• Throughput segments: 100 Mb, 1 Gb, 10 Gb, 40 Gb, 100+ Gb

• $400 mm or 67% of Arista’s Q1 2019 Revenue, from the 100+ Gb switch category

• Large service providers and hyperscale cloud providers were the first to adopt 100 Gb networking switches

• Due to falling costs and increased need for high bandwidth and low-latency switches, more demand will come from traditional enterprises for 100 Gb throughput switches

• In 2018 Arista developed a 400 Gb ethernet switch series and competitors like Cisco quickly followed

Arista’s positioning

• As the amount of data increases and cloud computing becomes more prevalent, higher and higher throughput switches will be demanded

• Through its software capabilities, Arista will allow for more traditional businesses and campuses to adopt higher throughput switches

• Long-term, this will allow for Arista to diversify customer base and limit dependence on cloud Titans

• Meanwhile, Cloud titans will continue to demand increasingly high throughputs of over 400 Gb

• As a leading innovator in the ethernet switches market, Arista has the ability to capitalize first on this new demand

3. Market Overreaction to Q3

8

In Q3 2019, Arista Network lowered guidance for both Q4 ’19, and 2020.

This guidance was a result of a decrease in demand from one of their “Cloud Titans.” ANET services two cloud titans, Microsoft and Facebook, and they have explicitly stated that the decrease in demand was not a result of Microsoft, so we can assume it was Facebook.

$115 million in common stock repurchased at a weighted average cost per share of $224: “$1 billion stock repurchase program…to repurchase shares of our common stock opportunistically

The reduction in demand is a long-term problem in the cloud market, not just isolated to Facebook

The company is too dependent on concentrated revenue streams and the cloud

The “cloud” is not going to be as big of a money maker as people originally thought

Mojo merger and cloud campus is not significant

We also believe the market is finding it difficult to price ANET due to its lack of direct comps

ANET is currently developing and maturing multiple new revenue streams, including service revenue, the CloudVision, and are also spending lots on R&D to become a more broad provider of cloud network services, like Cisco.

ANET did not lose Facebook as a customer, and will continue to acquire new customers as demand for cloud services grows

The share repurchase program implies a long-term confidence in the fundamentals of the business

They operate in a high margin, rapidly growing industry and deserve to be trading at multiples over their “competitors”

5-Year Stock Chart Q3 2019

Market Analysis Our Analysis

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Risks and Mitigants

Risks

▸ Major Customer concentration

▸ The cloud networking industry is intensely competitive

▸ Compared to its competitors, Arista is a young business that has limited experience operating in different economic environments

▸ The cloud networking environment is rapidly evolving and current innovations do not guarantee future competitive advantages

▸ Rely on third parties for manufacturing coupled with limited visibility in cloud networking demand form Cloud Titans

▸ Potential for future litigation

Mitigants

▸ Arista has already begun to diversify its client base into campus networking and more traditional enterprises

▸ Arista is currently the market leader in high-end cloud ethernet switches and solutions and has durable competitive advantages

▸ Management team possesses significant experience, especially in the networking switches industry

▸ Focused approach on ethernet switches instead of full offering of networking solutions

▸ Provides flexibility in production possibilities in an extremely innovative industry

▸ Changes to patents have been made to avoid possible litigation in the future, and a settlement was made

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Final Recommendation

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Base Case

Price Target: $230.73Upside: 19.17%

Upside Case

Price Target: $315.31Upside: 63.21%

Downside Case

Price Target: $169.69Upside: -12.44%

Recommendation:Arista Network is a buy because it provides the best opportunity to get exposure into the rapidly expanding cloud service market due to its durable competitive advantages and the recent price action.

Appendix

11

Valuation – Comparable Companies Analysis

12

Valuation Statistics

Market Enterprise EV / Revenue EV / EBITDA Price / Earnings

Company Ticker Capitalization Value 2018A LTM 2018A LTM 2018A LTM

Cisco Systems, Inc. CSCO $186,193 $177,801 2.9x 3.4x 9.4x 11.0x 19.9x 17.5x

Motorola Solutions, Inc. MSI 28,246 33,454 2.8x 4.3x 10.8x 15.8x 23.1x 27.6x

Juniper Networks, Inc. JNPR 8,130 7,769 1.9x 1.8x 8.2x 10.9x 17.1x 23.0x

NETGEAR, Inc. NTGR 736 601 – 0.6x – 9.1x 26.8x 31.1x

Extreme Networks, Inc. EXTR 824 1,112 – 1.1x – 25.3x NM NM

Arista Networks, Inc. ANET $14,908 $12,564 9.7x 5.1x 32.4x 14.7x 48.4x 20.2x

Low $736 $601 – 0.6x – 9.1x 17.1x 17.5x

Mean 44,826 44,147 1.0x 2.2x 3.1x 14.4x 21.3x 23.9x

Median 8,130 7,769 – 1.8x – 11.0x 19.9x 23.0x

High 186,193 177,801 2.9x 4.3x 9.4x 25.3x 26.8x 31.1x

Operating StatisticsRevenue Revenue Growth EBITDA EBITDA Margin

Company Ticker 2018A LTM 2018A LTM 2018A LTM 2018A LTM

Cisco Systems, Inc. CSCO $48,005 $51,991 (2.5%) 3.4% $14,654 $16,207 30.5% 31.2%

Motorola Solutions, Inc. MSI 6,380 7,765 5.7% 10.2% 1,678 2,116 26.3% 27.3%

Juniper Networks, Inc. JNPR 5,027 4,418 0.7% (6.1%) 1,149 712 22.9% 16.1%

NETGEAR, Inc. NTGR 1,039 1,035 (9.1%) 29.5% 65 66 6.3% 6.4%

Extreme Networks, Inc. EXTR 607 1,011 16.8% -- 54 44 8.9% 4.4%

Arista Networks, Inc. ANET $1,646 $2,454 45.8% 21.3% $491 $857 29.8% 34.9%

Low $607 $1,011 (9.1%) (6.1%) $54 $44 6.3% 4.4%

Mean 12,212 13,244 2.3% 7.4% 3,520 3,829 19.0% 17.1%

Median 5,027 4,418 0.7% 3.4% 1,149 712 22.9% 16.1%

High 48,005 51,991 16.8% 29.5% $14,654 $16,207 30.5% 31.2%

Valuation – WACC

13

Capital Structure

Debt-to-Total Capitalization 0.59%

Equity-to-Total Capitalization 99.41%

Cost of Debt

Cost of Debt 5.10%

Tax Rate 21.00%

After-tax Cost of Debt 4.03%

Cost of Equity

Risk-free Rate(1) 1.82%

Market Risk Premium(2) 6.00%

Levered Beta 1.17

Cost of Equity 8.81%

WACC 8.79%

Debt Outstanding Amount Interest rate % of Total Weighted

Debt 1 $87 5.100% 100.0% 5.1%

Debt 2 0.000% 0.0% 0.0%

Debt 3 0.000% 0.0% 0.0%

Debt 4 0.000% 0.0% 0.0%

Debt 5 0.000% 0.0% 0.0%

Total Debt $87 5.1%

Current Share Price $193.68

Current Shares Outstanding 76.36

Equity Value $14,789.40

Total Debt $87

Total Equity $14,789.40

Valuation – DCF (Base)

14

FYE December 31, FYE December 31,

($ in millions) 2014A 2015A 2016A 2017A 2018A 2019E 2020E 2021E 2022E 2023E 2024E

Total Revenue $584.1 $837.6 $1,129.2 $1,646.2 $2,151.4 $2,517.1 $2,643.0 $3,171.6 $3,774.2 $4,415.8 $5,122.3

Revenue Growth -- 43.4% 34.8% 45.8% 30.7% 17.0% 5.0% 20.0% 19.0% 17.0% 16.0%

Expenses

COGS 192.0 294.0 406.1 584.4 778.0 881.0 925.0 1,110.1 1,321.0 1,545.5 1,792.8

Gross Profit $392.1 $543.6 $723.1 $1,061.8 $1,373.4 $1,636.1 $1,717.9 $2,061.5 $2,453.2 $2,870.3 $3,329.5

Gross Margin 67.1% 64.9% 64.0% 64.5% 63.8% 65.0% 65.0% 65.0% 65.0% 65.0% 65.0%

SG&A 117.7 184.8 206.1 241.9 249.1 327.2 370.0 475.7 641.6 839.0 1,024.5

R&D 148.9 209.4 273.6 349.6 442.5 528.6 581.5 713.6 905.8 1,104.0 1,331.8

Operating Expenses 266.6 394.2 479.7 591.5 691.6 855.8 951.5 1,189.3 1,547.4 1,943.0 2,356.3

Operating Income (EBIT) $125.5 $149.4 $243.4 $470.3 $681.8 $780.3 $766.5 $872.2 $905.8 $927.3 $973.2

EBIT Margin 21.5% 17.8% 21.6% 28.6% 31.7% 31.0% 29.0% 27.5% 24.0% 21.0% 19.0%

Income Tax Expense (24%) 34.7 24.9 58.0 51.6 -39.3 163.9 161.0 183.2 190.2 194.7 204.4

EBIAT $90.8 $124.5 $185.4 $418.7 $721.1 $616.4 $605.5 $689.0 $715.6 $732.6 $768.9

Cash Flow

Plus: D&A 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Discretionary Cash Flow 90.8 124.5 185.4 418.7 721.1 616.4 605.5 689.0 715.6 732.6 768.9

Less: Increase in NWC 0.0 34.9 (140.5) (5.0) 53.3 (496.3) (93.7) (176.6) (107.4) (154.5) (228.3)

Less: CapEx 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Free Cash Flow $90.8 $159.4 $44.9 $413.7 $774.4 $120.1 $511.9 $512.5 $608.2 $578.1 $540.5

Free Cash Flow Growth -- 75.5% (71.8%) 821.4% 87.2% (84.5%) 326.1% 0.1% 18.7% (4.9%) (6.5%)

Unlevered Free Cash Flow

WACC 8.79%

Discount Period 0.5 1.5 2.5 3.5 4.5 5.5

Discount Factor 0.96 0.88 0.81 0.74 0.68 0.63

Present Value of Free Cash Flow $115.2 $451.1 $415.2 $453.0 $395.8 $340.1

Valuation – DCF (Base)

15

Enterprise Value DCF Sensitivity Analysis

Cumulative Present Value of FCF $2,170.3

Terminal Value

Terminal Year EBITDA $973.2

Exit Multiple 24.0x

Terminal Value $23,357.9

Discount Factor 62.93%

Present Value of Terminal Value $14,698.8

% of Enterprise Value 87.1%

Enterprise Value $16,869.1

DCF Implied Equity Value and Share Price


Less: Total Debt $87.1

Plus: Cash & Cash Equivalents $1,956.0

Implied Equity Value $18,738.0

Implied Share Price $245.39

Shares Outstanding 76

Comps Implied Equity Value and Share Price







DCF Sensitivity Analysis

WACC

245.39 6.8% 7.8% 8.8% 9.8% 10.8%

22.0x $250.09 $239.42 $229.36 $219.87 $210.92

23.0x $258.97 $247.86 $237.38 $227.50 $218.18

EV/EBITDA 24.0x $267.85 $256.29 $245.40 $235.13 $225.43

25.0x $276.73 $264.73 $253.42 $242.75 $232.69

26.0x $285.62 $273.17 $261.44 $250.38 $239.95

Method Weight Price

Comparable Companies 15% $147.6

DCF 85% $245.4

Fair Value Estimate $230.72

Valuation – DCF (Upside)

16

FYE December 31, FY December 31,

($ in millions) 2014A 2015A 2016A 2017A 2018A 2019E 2020E 2021E 2022E 2023E 2024E

Total Revenue $584.1 $837.6 $1,129.2 $1,646.2 $2,151.4 $2,517.1 $2,819.2 $3,439.4 $4,127.3 $4,870.2 $5,746.9

Revenue Growth -- 43.4% 34.8% 45.8% 30.7% 17.0% 12.0% 22.0% 20.0% 18.0% 18.0%

Expenses

COGS 192.0 294.0 406.1 584.4 778.0 881.0 986.7 1,203.8 1,444.6 1,704.6 2,011.4

Gross Profit $392.1 $543.6 $723.1 $1,061.8 $1,373.4 $1,636.1 $1,832.5 $2,235.6 $2,682.7 $3,165.6 $3,735.5

Gross Margin 67.1% 64.9% 64.0% 64.5% 63.8% 65.0% 65.0% 65.0% 65.0% 65.0% 65.0%

SG&A 117.7 184.8 206.1 241.9 249.1 302.1 366.5 481.5 660.4 876.6 1,091.9

R&D 148.9 209.4 273.6 349.6 442.5 503.4 563.8 722.3 866.7 1,022.7 1,321.8


Operating Income (EBIT) $125.5 $149.4 $243.4 $470.3 $681.8 $830.7 $902.1 $1,031.8 $1,155.6 $1,266.3 $1,321.8

EBIT Margin 21.5% 17.8% 21.6% 28.6% 31.7% 33.0% 32.0% 30.0% 28.0% 26.0% 23.0%


EBIAT $90.8 $124.5 $185.4 $418.7 $721.1 $656.2 $712.7 $815.1 $913.0 $1,000.3 $1,044.2

Cash Flow

Plus: D&A 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Discretionary Cash Flow 90.8 124.5 185.4 418.7 721.1 656.2 712.7 815.1 913.0 1,000.3 1,044.2


Less: CapEx 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Free Cash Flow $90.8 $159.4 $44.9 $413.7 $774.4 $159.9 $619.7 $621.5 $803.4 $792.9 $790.1

Free Cash Flow Growth -- 75.5% (71.8%) 821.4% 87.2% (79.4%) 287.6% 0.3% 29.3% (1.3%) (0.4%)


WACC 8.79%

Discount Period 0.5 1.5 2.5 3.5 4.5 5.5

Discount Factor 0.96 0.88 0.81 0.74 0.68 0.63


Valuation – DCF (Upside)

17



Terminal Value

Terminal Year EBITDA $1,321.8

Exit Multiple 26.0x






Implied Equity Value and Share Price















WACC

344.90 6.8% 7.8% 8.8% 9.8% 10.8%

22.0x $329.47 $314.99 $301.34 $288.47 $276.32

23.0x $341.53 $326.45 $312.23 $298.83 $286.18

EV/EBITDA 26.0x $377.72 $360.83 $344.91 $329.90 $315.74

27.0x $389.79 $372.29 $355.81 $340.26 $325.60

28.0x $401.85 $383.75 $366.70 $350.62 $335.45

Method Weight Price


DCF 85% $344.9


Valuation – DCF (Downside)

18

FYE December 31, FY December 31,

($ in millions) 2014A 2015A 2016A 2017A 2018E 2019E 2020E 2021E 2022E 2023E 2024E

Total Revenue $584.1 $837.6 $1,129.2 $1,646.2 $2,151.4 $2,517.1 $2,492.0 $2,865.8 $3,295.6 $3,790.0 $4,358.5

Revenue Growth -- 43.4% 34.8% 45.8% 30.7% 17.0% (1.0%) 15.0% 15.0% 15.0% 15.0%

Expenses

COGS 192.0 294.0 406.1 584.4 778.0 906.2 897.1 1,031.7 1,186.4 1,364.4 1,569.0

Gross Profit $392.1 $543.6 $723.1 $1,061.8 $1,373.4 $1,611.0 $1,594.9 $1,834.1 $2,109.2 $2,425.6 $2,789.4

Gross Margin 67.1% 64.9% 64.0% 64.5% 63.8% 64.0% 64.0% 64.0% 64.0% 64.0% 64.0%

SG&A 117.7 184.8 206.1 241.9 249.1 352.4 373.8 429.9 560.3 720.1 871.7

R&D 148.9 209.4 273.6 349.6 442.5 553.8 573.2 687.8 823.9 985.4 1,220.4


Operating Income (EBIT) $125.5 $149.4 $243.4 $470.3 $681.8 $704.8 $647.9 $716.4 $725.0 $720.1 $697.4

EBIT Margin 21.5% 17.8% 21.6% 28.6% 31.7% 28.0% 26.0% 25.0% 22.0% 19.0% 16.0%


EBIAT $90.8 $124.5 $185.4 $418.7 $721.1 $556.8 $511.8 $566.0 $572.8 $568.9 $550.9

Cash Flow

Plus: D&A 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Discretionary Cash Flow 90.8 124.5 185.4 418.7 721.1 556.8 511.8 566.0 572.8 568.9 550.9


Less: CapEx 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Free Cash Flow $90.8 $159.4 $44.9 $413.7 $774.4 $60.9 $458.6 $434.8 $506.3 $451.7 $364.9

Free Cash Flow Growth -- 75.5% (71.8%) 821.4% 87.2% (92.1%) 653.4% (5.2%) 16.4% (10.8%) (19.2%)


WACC 8.79%

Discount Period 0.5 1.5 2.5 3.5 4.5 5.5

Discount Factor 0.96 0.88 0.81 0.74 0.68 0.63


Valuation – DCF (Downside)

19



Terminal Value

Terminal Year EBITDA $697.4

Exit Multiple 22.0x






Implied Equity Value and Share Price















WACC

173.57 6.8% 7.8% 8.8% 9.8% 10.8%

20.0x $175.82 $168.75 $162.09 $155.80 $149.86

21.0x $182.18 $174.80 $167.83 $161.26 $155.06

EV/EBITDA 22.0x $188.55 $180.84 $173.58 $166.73 $160.26

23.0x $194.91 $186.89 $179.33 $172.19 $165.46

24.0x $201.28 $192.94 $185.07 $177.66 $170.66

Method Weight Price


DCF 85% $173.6


arista networks nyse: anet recommendation: buy · q1 '17 q2 '17 q3 '17 q4 '17...

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