Cloud computing is computing in which large groups of remote servers are networked to allow centralized data storage and online access to computer services or resources. The McKinsey Global Institute, in its influential 2013 study on disruptive technologies, estimates that by 2025 over 90% of U.S. businesses and public institutions will be hosting critical applications in the cloud. Recent surveys have found only 54% are utilising this service. There is still a growth opportunity here, not only in the US, but globally as well.
The “cloud’ has been around since the 1950s when businesses could rent time on mainframes. However the concept really took off after the dot-com bubble burst in the early 2000s with the widespread availability of high-capacity networks and low-cost computers, together with the widespread adoption of virtualization and service-oriented architecture. Who plays in this space? The usual suspects, of course – IBM, Cisco, Amazon, Google, Microsoft, Salesforce.com, and VMware.
One of the main barriers to total adoption of the cloud is network capacity; the related costs of upgrading and speed of implementation. That brings us to Santa Clara (California) based Arista Networks.
Arista Networks delivers software driven cloud networking solutions for large data centres and high-performance computing environments. There are more than two million cloud networking ports being deployed worldwide. Arista is addressing this market with a portfolio of 1/10/40 and 100GbE products that redefine network architectures, provide scalability to networking, and dramatically change the price/performance of data centre networks.
Arista specializes in the data centre where the massive amount of internet traffic from websites and mobile apps is managed. Its main competitor is Cisco Systems, which has a 70% market share in “legacy” network switches and software. Arista (and many analysts) believe that these older installations are inefficient and won’t be able to carry the increased traffic load of data. Global internet traffic has increased fivefold over the last 5 years and is predicted to increase at least another three times by 2020.
Arista’s Extensible Operating System (EOS) is programmable and modular, and is built on standard Linux, which allows customers to develop their own software applications as well as integrate with off-the-shelf Linux-based applications, a substantial departure from the closed-system approach of legacy networking equipment and providers such as Cisco. This is Arista’s competitive advantage and why it is disrupting the data centre switching space.
Arista is a growth stock, pure and simple. In their latest earnings report for Q1 2016, revenues of $242.2 million were up 35.3% Y/Y, and was above prior guidance of $232-$240 million. EPS of $0.68 beat also beat the Street estimate of $0.61. Q2 guidance for revenue of $259 - $265 million exceeded consensus implying 34% Y/Y growth at the midpoint. Analysts see a 25-30% revenue CAGR to 2018.
Arista continues to benefit from the product cycle that began in September 2015 with its “Tomahawk” based products with port speeds of 25/40/50 Gbps that are driving an upgrade cycle at some of its largest Cloud customers such as Microsoft and Facebook. Analysts believe that Arista’s mix of high-speed ports grew to nearly 30% in 2H’15 up from ~20% in 2014. With the release of additional port speed configurations (the 100Gbps 7500R spine switch based on Broadcom’s Jericho silicon) analysts also expect further revenue momentum through 2016/2017 as the data centre switching market continues to transition to higher speed ports. Given Arista’s positioning with customers and its ability to support cloud infrastructures based on its software capabilities, Arista is a net beneficiary from this multi-year port speed transition by its largest customers.
The World of Lawsuits
Investing in disrupters is not always straightforward… Here, there is a “fly in the ointment” – a lawsuit involving 14 patents with its main competitor Cisco.
Lawsuit risks are unquantifiable. Analysts can estimate potential damages, but they are just that – educated guesses based on similar cases. Arista obviously does not believe they have infringed on Cisco’s patents or intellectual property and noted the Arista EOS operating software was developed from scratch from a blank sheet. It is worth noting that the heart of ANET's differentiation from Cisco is in its Linux-based programming which is radically different to the Cisco programming.
It is also worth noting that Cisco claims that Arista is using technology invented when its founders, leaders, and employees worked at Cisco. Former Cisco employees include Arista’s famous billionaire co-founder Andy Bechtolsheim, who co-founded Sun Microsystems and later earned billions by angel investing in Google. Then there’s Arista’s CEO, Jayshree Ullal, who, prior to Arista, was a 15-year Cisco alum. She led Cisco’s core switching and networking division. A number of senior roles at Arista are held by former Cisco employees. So is this suit just “sour grapes” on Cisco’s part, reacting to the success of the new upstart?
Lawsuits in the U.S. also take an incredible amount of time to get through the courts. A similar lawsuit involving Juniper and Palo Alto Networks took 2.5 years. The company believes it will take “2-3 years” for resolution. Many patent infringements suits never get to court and usually lead to a settlement. It’s also unlikely that the lawsuit will alter customer buying behaviour. Recent results bear this out.
Focusing on the business at hand, drivers for Arista going forward are the growth of infrastructure supporting Big Data/IaaS/Web 2.0. It is estimated by industry observers that capex spending from the top ten Web 2.0/IaaS players will increase 20-50% annually over 3-5 years out of necessity. The Private Cloud/enterprise market has also discovered Arista's Linux programmability enabling SDN virtualization. This is a market that could grow 25%+ per annum.
Arista sales are currently 80% domestic. This is a significant positive in that there are very robust demand conditions in North America over the medium term. A number of technology companies have flagged sluggish conditions internationally and in emerging markets. Arista currently has very little exposure to these weak arenas.
That said, Arista does expect to drive strong international growth over the longer term. The company has stated that they are not going after the difficult BRIC markets, concentrating instead on the stronger European and larger industrialized APAC arenas.
Cisco becomes more aggressive in the data centre switching segment, resulting in slower share gains than forecast and pressuring revenue growth and gross margin;
- Changes in key customer Microsoft's cloud deployment plans or purchasing habits and/or share losses to competitors, resulting in lumpy revenue;
- Broader adoption of white box switching alternatives by the broader market, especially following Facebook's contribution of its Wedge architecture to the Open Compute Project, resulting in slower share gains than forecast, and resulting in slower revenue growth, and pressuring gross margin;
- Ongoing litigation impacts cash flows: company must raise cash through share offerings.
- Outcome of litigation is unfavorable to Arista, impacting cash flows and potentially disrupting its business and/or resulting in a cash settlement.
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