EUR 850.00 For Business Accounts Only

Morningstar | Arista's Installation Base Growth Expected to Continue; Raising FVE to $251

After taking a fresh look at Arista Networks, we are raising our fair value estimate to $251 per share from $207; increasing our moat rating to narrow from none; and raising our moat trend to positive from stable. The impetus for a narrow moat stems from Arista's expanding installation base creating customer switching costs, while the positive moat trend is due to high reorder rates creating even greater stickiness, in our view, with critical customers. We believe Arista's market share gain in data centers will continue to drive mid- to high 20% revenue growth for the next two years, while continued expansion into higher profitable enterprise and campus markets will increase adjusted operating margins into the low 30% range longer term. We believe growth has already been priced in, making shares somewhat overvalued.

Management said that its top-line growth commitment at the expense of margin is not a cause for alarm, and we agree. We believe the company's focus on deploying capital into research and development to seed revenue expansion is the proper strategy in this nascent period of software-defined networking. In our view, the cloud service providers, representing 40%-50% of revenue, value Arista's software expertise, low-latency hardware, and 400 gigabit Ethernet roadmap. The cloud providers' buying power create a margin drag; however, we believe expected growth from a wider customer base of enterprises, service providers, and campuses will balance out gross margins in the mid-60s long term. Arista's EOS software and 100 Gb Ethernet hardware revolutionized the data center switching market by disrupting the status quo and lowering total networking ownership costs. Not resting on its laurels, we foresee that Arista's simplistic design of routing and switching products coupled with its software and service offerings will continue to increase its installation base with repeat customers and form new client adoption at the expense of competitors.

Arista Networks developed an expanding installation base through its focus and execution on software-based networking innovation, and we believe customers will remain loyal to the firm's Extensible Operating System software and peripheral products. Arista's initial growth came from high-frequency trading firms that found value in its low-latency switches and EOS. As an early vendor of 100-gigabit Ethernet switches, continued growth relied on cloud-based data center suppliers yearning for Arista's hardware architecture and EOS software innovation.

We think EOS' novelty lies in its single software image that provides a consolidated view of device activity from end to end and its ability to centrally upgrade the entire network. EOS contains leading software-defined networking features while remaining intuitive and fully programmable. Additional software offerings, like CloudVision, expand functionality and interoperability across networks. Bucking industry norms of requiring specific hardware per network function, some Arista switches double as routers after the functionality is unlocked through software licensing. Through software and hardware innovations, our view is that the company is staying true to its goals of driving network productivity and lowering network ownership costs.

In our view, cooperative development projects and product customization openness has yielded positive results with customers like large cloud-based companies and enterprises. To expand its customer base beyond cloud-based data center providers, enterprises, service providers, and financial institutions, Arista announced its intention to expand into the campus market. The adjacent move is due to requests from existing customers desiring one software platform across networking locations, and this part of the business will be ramping into fiscal 2020. Even with current customer concentration risk, we respect that Arista is growing alongside key customers and that new ventures have expanded from core competencies. Our opinion is Arista is well-positioned as a pioneer in the new age of software-defined networking and will continue to be a leader in next-generation switches and routers.

We believe that Arista's strengthening market position will continue even though the large market incumbents, with deep pockets and sprawling customer bases, are fighting back in the courtroom and marketplace. Regarding the legal concerns, we believe that Arista will get through its extensive legal battles with Cisco largely unharmed, or with minimal business disruptions, based on earlier favorable rulings from the International Trade Commission and review validation of redesigned products. Concerning the market environment, competitors are copying Arista's strategy of focusing on software features as the cloud continues to pull customers away from on-premises networking. Our view is that Arista's EOS and software variants will remain top choices for networking due to features, compatibility across vendors, and its simplicity to use and upgrade across the entire network. We believe Arista's well-thought-out, first-mover head start into software-defined networking caused EOS to spread enough to combat competitor offerings. This trend is indicative of Arista's move into the campus being requested by enterprise customers desiring continuity between networks, and the company's most critical customers being repeat buyers.

The company's strategic focus on software is confirmed by 90% of R&D personnel, or 55% of the company, being software focused. In our view, the strategic focus of software makes Arista differentiated in the networking space while keeping it a viable long-term business due to staying ahead of the market shift toward software-defined networking. We believe that the company's inroads with strategic cloud players plus growing customer list of enterprises and service providers makes the firm an acquisition target and a possible purchaser of firms that offer enhanced services like data analytics.