Security

Arista Networks: The Marketing Advantage – Arista Networks, Inc. (NYSE:ANET)


Arista’s (ANET) stock price fell by more than 35% off its high. But the fundamentals of the company didn’t change. Management even reported results above expectations during the last earnings. And the revenue is still expected to grow above 20% for the next quarters.

The stock price dropped below my estimation of fair value of $212. I’m still not buying as I require a margin of safety. But this drop is an opportunity to verify the validity of a key aspect of Arista’s success.

Revenue has been growing at a CAGR above 20% while net income margins gravitate at about 20%. A key factor to this performance is the low sales and marketing expense. But is it a sustainable advantage? Before answering this question, let’s see why Arista is unique from this perspective.

Server room - cloud data centerImage source: NeuPaddy via Pixabay

An exceptional profile

In the tech industry, the performance of Arista is exceptional. Companies that achieve a similar growth rate usually report a low – or negative – GAAP net margin.

The graph below compares the revenue growth of Arista with other network and security vendors. Cisco (CSCO) and Juniper (JNPR) are obvious references. I have chosen to include security vendors as there is no network vendor with Arista’s growth profile. And the security and network businesses are similar. They both sell hardware and software to build IT infrastructures.

ChartANET Revenue (Quarterly) data by YCharts

Over the last 4 years, Arista has been growing revenue at a higher rate than the other companies listed above. The growth is comparable with Palo Alto (PANW), Proofpoint (PFPT), and – to a lesser extent – Fortinet (FTNT), though.

The next graph compares the profits margins. I exclude Cisco and Juniper as their revenue don’t match Arista’s growth.

ChartANET Profit Margin (Annual) data by YCharts

While Arista has been generating net margins of about 20%, the other fast-growing IT companies delivered GAAP net margins between approximately -40% et +2%.

Besides the quality of the respective solutions the companies propose, there is one explanation for Arista’s exceptional performance. Sales and marketing expenses are way below what the other fast-growing tech companies spend as a percentage of revenue. And this advantage is not due to scale as all these companies generate annual sales in the range of $1 to $2.5 billion.

The 35%+ sales and marketing margin advantage for Arista is huge. The question of the health and the sustainability of such low expenses is legitimate.

Is the sales and marketing advantage sustainable?

There are many reasons for Arista to spend less on sales and marketing. But over the long-term, and considering Arista’s strategy, I expect the sales and marketing expenses (as a percentage of sales) to increase.

Let’s see why Arista can afford lower sales and marketing expenses and why this competitive advantage will diminish over time.

Arista started its business selling network switches and software to the cloud providers. Arista also addressed other verticals starting with big customers in a niche (banks with high-frequency trading activities).

The limited number of these customers and their scale favor low sales and marketing expenses. Acquiring one customer in the web-scale area can yield great results. As an illustration, management recently confirmed Microsoft (MSFT) still represented way more than 10% of sales at Q3 2018.

By turning to enterprises and smaller businesses, Arista will face a new challenge. The number of potential customers is more important than web-scale providers. But the sales potential per customer is much lower. Arista will need a more versatile and denser sales force.

The company will also have to adapt its sales strategy. Solutions will become more complex with the integration of the campus infrastructure. Sales teams will have to speak to different corporate levels instead of dealing with web-scale engineers. Check Point (CHKP) is currently following this path to address the weaknesses of its sales processes. In the Q3 conference call, Check Point mentioned the importance of reaching higher level management. The goal is to pitch sales of solutions and architectures at management level instead of speaking to engineers to sell a product.

The growth overseas will also increase the costs. Currently, U.S. sales still represented more than 72% of revenue during Q3 2018. And the three big web-scale providers (Amazon (AMZN), Alphabet (GOOG, GOOGL), and Microsoft) are American companies. So, the development overseas will not generate as much web-scale business as in the U.S.

Thus, the low sales and marketing expenses are not sustainable. But it’s not that bad for three reasons:

  • Lowering the importance of web-scale providers will improve gross margins as the other markets are less price sensitive. Management communicated the improvement of the gross margin would compensate for the higher sales and marketing expenses.
  • As Arista is gaining scale with the campus business, the margins will converge to Cisco’s margins. But even with sales and marketing expenses at 20% of revenue, the company will still generate healthy profits while growing.
  • Management doesn’t report revenue per segment, but considering the history of the company, the road is still long before the enterprise business overtakes the web-scale area. Arista announced only last year it would enter the campus area. And the company will maintain this exceptional trajectory as long as the web-scale providers grow.

For the next quarters, I will check the sales and marketing expenses and the costs of revenue progress in opposite directions. If that’s the case, there’s no reason to worry about the higher sales and marketing expenses.

Valuation

I highlighted in my last article about Proofpoint the recent convergence of the valuations for the fast-growing IT security companies.

Despite its unique combination of revenue growth and high net margins, Arista is no exception to this valuation trend. The market values the company at an EV/Revenue (Forward) ratio of 5.

ChartANET EV to Revenues (Forward) data by YCharts

That doesn’t mean the market is offering a bargain as I estimate the other high-growth IT company overvalued. But at least, Arista is a bargain relative to these peers.

As there is no change to the fundamentals of the company and considering the sustainability of the margins, I keep my estimation of the fair value at $212 per share.

Conclusion

The company reported last earnings above expectations. The fundamentals didn’t change. Yet, the stock price dropped by more than 35% off its highs about 6 months ago.

Due to the nature of its business with web-scalers, Arista has been growing at a fast rate while generating high net margins. Even if sales and marketing expenses will not stay so low over the long-term, the company will still generate high margins and growth for the foreseeable future.

Yet, the market values the company at the same EV/Sales ratio as other fast-growing IT companies that generate GAAP losses. Considering the fundamentals are still solid, I keep my estimation of fair value at $212 per share.

Disclosure: I am/we are long CSCO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.





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