Wednesday, July 8, 2020

Arista Networks- riding the cloud computing wave with potential upside

I got to know Arista Networks (NYSE:ANET) through Motley Fool's article back in 2019 as I was browing through its website. Back then, the stock was trading at its peak level of $324 and it rode on the growing demand of cloud computing. I added 5 shares without giving a second thought and 6 shares at $195.77 to average down. Currently it is trading at $210.78 (8 July).

It had a good run since it was listed in NYSE and the stock trended downwards after it reported its first quarter earnings on 2nd May. Although results showed a solid set of numbers with revenue growth of 26%, the drop was attributed to forward guidance on slowdown in orders from tech titan, which was believed to be Microsoft. Despite assuring investors it was a short term issue, it gapped down and opened at $261 the following day.

Earnings forecast continued to disappoint on 3rd quarter with another cloud titan cutting down orders. Despite several quarters of earnings disappointment,  I felt that its current pe ratio of 21.66  is whole lot more reasonable in valuation compared to the past years. Here's why:


Very strong Balance Sheet


Today, many tech companies listed in Nasdaq reported earnings loss, huge pile of debt and analyst continues to be bullish on its outlook. They could be in their growth phase with much growth catalyst. However, Arista Networks is unlike any of these. It has a strong balance sheet with minimal debt and large pile of cash. In fact during uncertain times that we are going through, companies with strong balance sheet stands the test of time and could emerge stronger post covid. Its cash & cash equivalents and marketable securities accounts for more than 50% of its balance sheet because it is able to consistently generate free cash flow. Its cash has been growing every year too.  I remembered reading investment books in the past which describes two kind of stocks investors should own: growth stocks or value stocks. In the case of Arista, you have can have the best of both worlds, tapping onto the growth in cloud computing and trading at relatively attractive valuations.

Its future growth in Data Centre Network & Artificial Intelligence

Under such challenging time, when many companies earnings forecast are in doubt, I think this company could be one of the Covid 19 beneficiary. The virus has actually speed up the adoption in digital transformation. CEO of Microsoft , Satya Nadella said: We have seen two years worth of digital transformation in two months.

It is a matter of time when the world recovers from Covid19 with more face to face interactions, but the new normal will change the way we do business, socialize and leisure.Given a choice, employees would still opt for online meetings to save traveling time and more cost effective. Consumer may prefer to catch the latest Netflix show at the comfort of their home over a cinema trip.

All these meant a rising demand for strong network infrastructure and Arista stands to benefit from the growth. When consumer are obsessed with online games, Facebook streaming and riding on the Netflix bandwagon, it will cause an sizable strain in the Ethernet connectivity, speaking from the server side of things. While the current 400G switches were only developed around two years back, 800G is getting underway - currently in its stage of standards perfection and testing before rolling out. This meant that Arista will stand to benefit from sales of network switches as companies constantly upgrade their switches to accomodate higher networking speed.




Leader in Data Centre Networking





Arista has been stealing Cisco's market share in switch market share in the past years, however, there's still much competition among big names, such as Juniper Networks, Huawei etc. One of the reasons which makes Arista stands out is its amazing operator experience i.e. great customer experience. In the video, Arista's COO mentioned that it only takes 18 seconds for a person to reach a real life Arista staff to assist in his query, and not a machine and they are the not operator assistance to transfer your call to a technician, but are trained support staff who can solve your problems. Checkout the video here: https://www.youtube.com/watch?v=6FTrdjF3Hoc&t=314s

Secondly, in terms of  Data Centre Networking, Arista has beeen ranked as a leader in 2019 Magic Quadrant for 5th Consecutive Year. To be ranked as a leader means excelling in both vision and execution. This means that they have a clear understanding of market needs, and ability to stay competitive and come out with innovative solutions to be well postioned for tomorrow.




Valuation

Since Arista doesn't pay dividend, valuing the stock using Dividend Discount Model is not possible. I will use DCF since it generate substantial Free Cash Flow.

I will use CAPM to determine the Discount Rate.

Beta=1.16 (as of 5th July)

Market Risk Premium =5.6%



Risk Free Rate= 0.69


Discount Rate= Risk Free + Beta x Market Risk Premium
                      =  0.69 + 1.16 x 5.6
                      = 7.186

I would use a growth rate of 5 % till 2024 and a terminal growth rate of 2% from year 2025 onwards.

Capex = Purchase of Property Plant & Equipment + Business Acquistions. 
Arista Networks aquired Mojo Networks in 2019 and purchased Big Switches in 2019. As it is more of a one time purchase, I won't be including any projection of business acquisition for 2020 onwards.

Average 5 year of Purchases of PE = $19,254,000. Its 5 year trend did not show an increase in purchases of PE with a rise of Revenue over the year, hence I would set the future Capex to be $20mil.


Summing the all the years of Free Cash Flow per share= $263.48

Since Arista is in a net cash position, and sitting on a pile of cash, I am inclined to include its cash & Equivalents and Marketable Securities to calculate intrinsic value. It was mentioned in its annual report that marketable securities are highly rated securities with the objective to minize potential risks of principle loss. Returns may be low but it's also for the purpose to meet working capital needs when they may require access to liquditiy. Moreover Cash, Cash Equivalents and Marketable Securities were lumped as one category in Consolidate Balance Sheet Data in its AR

Value of Cash+ marketable Securities= $2,724,368,000
Outstanding shares as of 2020 =76,264,000
Cash+ Marketable Securities/share= $35.72

Present Value of Arista Networks= USD 299.20

My Transactions



What's your view on Arista. Would you invest at current prices?


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