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Morningstar | Cloud Titan Spending Pause is a Speedbump to Arista's Momentum; Maintaining FVE of $280. See Updated Analyst Note from 02 May 2019

Narrow-moat Arista Networks reported another robust quarter of growth. However, next quarter's growth is expected to be hampered by an important cloud titan customer pausing its spending. Revenue growth of 26% year over year was in line with our expectations while operating margin of 33% exceeded our forecast due to controlled R&D and sales and marketing expenditures. Although the cloud titan, which we assume is Microsoft, pausing demand causes us to lower our expected revenue growth for the upcoming quarter and year, we still expect margin expansion from selling to a more diversified customer base, controlled costs, and next generation product sales. Due to these reasons and an expectation of the cloud titans to have a healthier back half of 2019, we are maintaining our fair value estimate of $280 per share. The stock has fallen from $311 to $258 after hours, now making shares slightly undervalued.

Compared with the prior year, product revenue grew by 24% and service revenue increased by 39%. Gross margin stayed consistent around 64% while operating margin expanded to 32.6% from 29.4% year over year. In the quarter, Arista's EPS of $2.47 benefitted from a 3% tax rate due to the finalization of tax reform positions. Next quarter's guidance included 16% annual revenue growth at the midpoint, with a possible uptick in gross margin due to the customer mix being shifted away from cloud titans. Management was hesitant to extrapolate full-year expectations based on the second-quarter slowdown, and we believe this speedbump should be temporary as Arista continues its journey into the higher margin financials, enterprise, and campus markets. In our view, Arista is doing a fine job of balancing margins and operating expenditures as it pushes into new customer markets, ramps up hiring, and expands its global reach.

Arista recorded a new record for million-dollar customers in the quarter, exceeding the previous record set last quarter. The company is adding new customers at a rate of 1 to 2 a day, and we do not expect this trend to slowdown as new opportunities open up in sectors like cloud, technology, finance, and campus. The leading vertical of cloud titans was followed by enterprises as Arista's second-largest customer segment, followed by financials, cloud specialty providers, and then service providers. We expect the enterprise segment to continue its growth as Arista expands its portfolio with items like wireless products for the campus through its Mojo acquisition and ultra-low-latency solutions for financial entities through its Metamako acquisition. In the quarter, Arista announced its board authorized a three-year $1 billion share repurchase program that will be solely funded through working capital.