Investor Essentials Daily

Arista Networks was our cloud winner of the year

Arista Networks, Inc. (ANET)
December 28, 2021

In early 2021, the market was still full of irrationality. Early into the vaccine rollout, investors weren’t sure whether At-Home stocks were doomed, or if they still had room to run.

Part of the problem was bad as-reported accounting data. Without knowing if a company is truly profitable, it’s almost impossible to make a good call. By looking at the Uniform Accounting data, we were able to identify a company poised to make a mint on the cloud, and it ended up being one of the best performers of the year. Today, we’ll revisit why we liked the cloud company in February.

Also below, the company’s updated Uniform Accounting Performance and Valuation Tearsheet.

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Continuing our ‘best of 2021’ series for the Investor Essentials Daily, today we’re highlighting the biggest winner of the year: Arista Networks (ANET).

We originally wrote about Arista on February 16th, where we highlighted that a mix of as-reported accounting and the vaccine rollout caused investors to throw many At-Home Revolution stocks aside.

While not every winner of the At-Home trend is sustainable, many others still have long-term tailwinds. For instance, the cloud was a trend long before the pandemic. That said, the last 18 months of working from home pulled the trend ahead by several years, and that progress isn’t going anywhere.

Arista Networks is a key supplier to data centers and cloud operators, and we saw that it was a massively profitable business.

As 2021 progressed, investors learned which At-Home trends were here to stay, including the cloud. That’s why Arista is up 69% since we highlighted it in February. Here’s why we liked it back then.

Here at Valens, we often talk about how big changes in society can lead to radically different spending habits over time. For example, the work-from-home movement has accelerated demand for speakers, cars, and boats.

Families spent plenty on their homes before, but in 2020, the home became one of the only things to spend money on.

Twenty years ago, working from home on this scale would have been impossible. Employees would struggle to communicate ideas and share work. Services like Slack (WORK), Zoom (ZM), and Microsoft Teams (MSFT) make remote communication possible.

To help employees share their work seamlessly, companies are now turning to the cloud. Along with its many other benefits, the cloud enables individuals to perform numerous tasks remotely.

While the cloud has existed for several years now, 2020 saw corporate adoption of cloud services spike.

With the advancements of cloud technology and its increasingly valuable offerings, data centers have become more prevalent than ever before. As the cloud is someone else’s computer accessed from the internet, these platforms have to exist somewhere.

Arista Networks (ANET) is one of the key suppliers to data centers. The company is a critical provider of systems that enable the cloud to run efficiently.

In addition, Arista is a prominent provider of networking hardware and software. It is able to differentiate itself through creating tailored networking solutions for any data center size.

Investors might assume this company generates robust returns, as data centers are powering this societal transition to the cloud.

However, on an initial look using as-reported metrics, it looks like the firm hasn’t been able to differentiate itself from market returns.

Diving deeper into the as-reported metrics, Arista Networks’ return on assets has remained consistent—around corporate averages over the past eight years. Specifically, ROA declined from 14% in 2012 to 10% in 2015. Since then, ROA has risen back to 14% levels in 2019.

Investors might see Arista’s returns and assume that without a competitive advantage, Arista is only able to see returns hover right around the corporate average of 12%.

Looking through a Uniform Accounting lens, it becomes clear that the firm’s business model is even better than it appears. Due to distortions around excess cash and R&D in GAAP accounting, profitability has been artificially suppressed.

Specifically, Uniform ROA has been at least two times greater than the as-reported metrics since 2012.

Once we make the necessary Uniform Accounting adjustments, we can see Arista Networks has in fact generated returns well above the as-reported numbers.

While Uniform ROA faded from 39% in 2012 down to 26% in 2015, since then, it peaked at 44% in 2018 before settling around 40% in 2019. This can be attributed to the firm’s surging demand. Arista is currently in the enviable position of supplying a booming market.

Without Uniform Accounting, investors are unable to understand the context of macro trends to invest in, such as the At-Home Revolution. The bedrock of investing is understanding a company’s fundamentals. With such distortions in a name like Arista Networks, any GAAP powered analysis will be no better than guesswork.

SUMMARY and Arista Networks, Inc. Tearsheet

As the Uniform Accounting tearsheet for Arista Networks, Inc. (ANET:USA) highlights, the Uniform P/E trades at 43.7x, which is above the global corporate average of 24.0x and its historical average of 28.0x.

High P/Es require high EPS growth to sustain them. In the case of Arista Networks, the company has shown a 27% decline in Uniform EPS in the previous year.

Wall Street analysts provide stock and valuation recommendations that provide very poor guidance or insight in general. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.

We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Arista Networks’ Wall Street analyst-driven forecast is a 70% EPS shrinkage in 2021, followed by an 31% EPS growth in 2022.

Based on the current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify Arista Networks’ $130 stock price. These are often referred to as market embedded expectations.

The company would need to grow its Uniform earnings by 25% per year over the next three years to justify current stock prices. What Wall Street analysts expect for Arista Networks’ earnings growth is below what the current stock market valuation requires in 2021, but above that requirement in 2022.

Furthermore, the company’s earning power is 4x the long-run corporate average. Also, cash flows and cash on hand are over 9x its total obligations—including debt maturities and capex maintenance. Together, this signals a low credit risk.

To conclude, Arista Networks’ Uniform earnings growth is below its peer averages, but the company is trading above peer average levels.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

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