Arista Networks, Inc. (NYSE:ANET) Credit Suisse 26th Annual Technology Conference November 29, 2022 2:20 PM ET
Company Participants
Ita Brennan – Chief Financial Officer
Conference Call Participants
Sami Badri – Credit Suisse
Sami Badri
All right. Thank you everyone for joining us. I’m Sami Badri with Credit Suisse. And right now, we’re going to kick it off with Arista Networks and the CFO, Ita Brennan. Thank you very much for joining us.
Ita Brennan
Thanks for having us.
Question-and-Answer Session
Q – Sami Badri
All right. So, something not as topical as the soccer game that’s going on today. But very topical for you guys is your recent Analyst Day that you had in Santa Clara. So, following the introduction of new total addressable markets and product launches and even a new long-term growth rate, what has been the investor feedback or at least kind of inputs that you’ve received on some of the things you announced or just the growth that you’ve guided to?
Ita Brennan
Yes, I think the feedback on the Analyst Day overall has been pretty positive, right? I think we’re resonated with investors was the — on the one hand, you have the cloud story, the AI kind of drivers of that cloud story over time, resonated well and just understanding kind of how AI underpins that business.
And then on the other hand, we’ve spent a lot of time to talk with folks just about the enterprise platform and the expansion of that and the addition of capabilities to that and essentially filling in the pieces of that kind of end-to-end enterprise solution. And so there was a good receptivity seeing kind of us continue to add to that enterprise solution as well.
So, net-net, I think it was positive, some discussion around gross margin. I mean I think — I do think supply chain is not completely solved yet, I think that’s our view. We’ll see how it plays out as we go through the year, but we were assuming obviously that we continue to have some issues around supply chain well through the year and the consequent kind of impact on gross margin asset we’ve spent some time talking about that as well. But I think overall, there’s a good growth outlook for next year, I think underpinned by two strong drivers in the business, and that was pretty well received.
Sami Badri
Got it. Got it. Just to double-click on two things you announced, the networking-as-a-service solution and also the routed WAN solution you first initially launched at your Analyst Day. One thing that I think people want to get a better idea on how does this shape Arista going forward, at least longer term? What are these two product and solution announcements actually due to kind of reposition Arista as almost like a company or a platform for the market?
Ita Brennan
Yes, I think it’s a continuation of what we’ve been doing in the enterprise. And if you think about Arista five years ago, we were selling data center-only into an enterprise customer. Then we added routing, then we added campus, we’ve added visibility, monitoring, security within the network. And so we’re filling in kind of holes, if you like, in that overall offering over time.
So, the routed WAN for sure, is something that we’re solutioning today with partners and other vendors. And the more of that, that we can do ourselves, leveraging US, bringing that kind of more directly kind of into the overall solution. That’s very positive.
So I think that’s something that we’ll start to ship next year. It will obviously take some time to drive revenue not dissimilar to campus when we launched the campus originally, products originally, but it’s an important piece of the puzzle from a customer perspective and from an overall solution for customers.
The network-as-a-service and the automation around that, I mean, this is kind of something that Ken is hugely passionate about, and that’s a continuation of leveraging some of the differentiation of US to make a network operator’s life easier, better, more efficient, right? And being able to pre-deploy your network effectively, right?
It seems like such a simple thing, but it’s been really difficult to be able to do in the networking space. But to be able to actually — and we saw some of this as we went through COVID as well, but be able to pre-deploy your network, test it, make sure it’s going to work before you ever actually push it into the live environment from a networking operator perspective, that’s a really big deal.
It doesn’t sound like a big deal to us necessarily, because there’s lots of things that work that way, but the network hasn’t really worked that way. So again, it’s a further incident continuation. I don’t know if there’s a big step function change. It’s more a continuation of things that we think are important to kind of growing that enterprise business and taking care of those customers over time, and things that the team have been building towards being able to do for some time and largely leveraging US.
Sami Badri
Yes. I mean, I guess we can’t really relate to how it feels to roll out a new network, because we’ve never really been in a seat where we’re clicking the actual deployment button, right, probably a little bit more, I want to say, challenging to be in that seat and roll out.
Ita Brennan
Yes. It’s interesting to say roll back was such a big deal to be able to roll back something was like hugely important to networking folks. But why roll it out at all, if you if it doesn’t work, right? And I think that’s kind of the next step is to say, I’m going to pre-test it as opposed to putting it in and then being able to roll it back. I mean, that’s better than not being able to roll it back. But really, the reality is being able to pre-test and pre-stage some of the stuff is very important.
Sami Badri
When we think about network-as-a-service and the router WAN market, where do you believe Arista is going to be able to materialize market share or traction, the fastest or the best, at least once these solutions become more commercial and then rolled out?
Ita Brennan
Again, it’s focused on the enterprise piece of the business, right? I mean, our target market, if you like, within that, is that large enterprise market. So it’s absolutely targeting those customers as a first — both of those offerings are targeting those customers. So I think that’s where we’ll see it deployed for it. I mean, it’s probably something we’ve been talking with customers about. It’s not something that we’re kind of dropping and without having some free discussion with customers, et cetera. So it is something that is important to customers they’ve been asking us to do. And it’s just another piece of that solution.
Sami Badri
And then when we talk about the router WAN opportunity in your announcement, right, there were a lot of elements that were announced at the Analyst Day for why you guys were going to basically create something from scratch and then roll it out in a very Arista as kind of way. Could we talk about some of the key differentiations on what you guys are doing versus what the existing market solutions are doing that has opened up this opportunity for you?
Ita Brennan
Yes. I mean, probably one of the biggest factors is it fits on the US platform, right, and it’s leveraging the US. So that means all of the advantages of that end-to-end operating system now accrete to that as well, right? So that’s an important part.
Technically, I think that there’s more optionality in terms of how you connect those networks. And again, there’s other folks in Arista that would do this better than I will, but there is more optionality in terms of how you connect the network. How you connect to the network, how you connect to the Internet versus connecting to MPLS versus connecting to other connection points? There’s more fluidity there and being able to select, which options you want to use. So, providing more standards-based and more kind of common avenues of connection, more standards-based hardware and then, again, filling in kind of part of the EOS being part of that whole US in-to-end operating system.
Sami Badri
Got it. I wanted to shift gears a little bit and talk about gross margins. So gross margin slightly ticked down in 3Q of 2022, and Arista was not an outlier by any means because a lot of the common equipment or hardware industries have seen gross margin pressures. But when we look out for the next 12 months to 24 months, is it safe to assume that margin profiles are relatively stable because you guys have submitted or at least put through a lot of purchase orders that locked in pricing to a certain degree? Then maybe two-part question here is, are things supposed to be a little bit stable going forward? And then our costs relatively locked in at least for the foreseeable future based on those purchase orders that were submitted?
Ita Brennan
Yeah. I mean, we had that chart in the Analyst Day, which had the circles, all the inter – into leading circles. And if we could have made them spend, we would have made them spin, because there’s a lot kind of happening at the gross margin level, right? You have let’s hopefully relatively short-term stuff like the decommits and the expedite fees where we’re still carrying probably a 200 basis point plus or minus impact of having to go into the broker market and solution parts because of this constrained kind of decommitted world that we’re living in.
You have obviously more systemic cost increases that we’ve seen over the last kind of 12 months, 18 months, which we passed on to customers in terms of pricing. We’re starting to see some of that pricing finally start to bring some benefit. We’re assuming that kind of helps because we are kind of improving off of the 61% to the 60%, 62%. We are improving a little bit in the outlook for 2023, assuming we get some help from pricing, but that the actual cost structure environment doesn’t change that much in that time frame.
In terms of – we have purchase commitments that go out a long time. There’s still going to be lots of – we talked about this a little bit at the Analyst Day as well, but we’ll continue to kind of look at that as lead times change, as supply dynamics change. We’ll continue to kind of push and pull on those purchase commitments over time. That’s not static per se.
So I think the real determinant of gross margin are going to still come back to mix. when do we get out some under the expedite fees and the decommits when can we get to a more predictable supply environment, which then lets you go back to driving for cost, driving for cost on the manufacturing side, driving from cost on the – on the component side. And until that happens, you’re kind of in this choppy world, where we’re kind of at the lower end of that range that we’ve seen more recently.
Sami Badri
On the topic of pricing specifically, are all customers seeing comparable or similar types of price increases or are some customers with very significant buying volumes, seeing slightly lower price increase relative to, say, smaller buyers?
Ita Brennan
No. I mean, we – so we did two price increases. We did one kind of major broad-based one back in November of last year. And that was adopted across the customer base pretty well accepted, because there was obviously clear cost increases, et cetera, that we could demonstrate and customers were willing to kind of offset those. We did a further one in April, which was targeting specific products. It wasn’t as broad.
Again, if that product was relevant to the customer, then it applied to the customers across. So I think we’ve gotten good acceptance across the customer base of those increases. We didn’t try to go back and ask customers to pay for some of the kind of expedite on the decommits because that’s just a very odd dynamic where you’ve had somebody waiting and then you decommit, and then you’re trying to make them pay for that, right? So we didn’t solution that piece. That’s been additive. We’ve been carrying that burden at the gross margin line ourselves.
Sami Badri
Got it. Got it. Something very topical, which is Meta’s recently announced CapEx and the results and then shortly after, they had to reduce that not by a significant amount, by an amount that caught people’s eye. One thing that maybe investors and at least ourselves are trying to understand is, how does this — how do these CapEx types of revisions impact Arista’s demand visibility, right? Is there — does it need to happen across, say the hyperscaler or customer base? Does it become like a magnitude question, or are you very insulated from a six to 12-month basis where these short-term kind of revisions of CapEx don’t necessarily affect you?
Ita Brennan
Yes. I mean, I think the first thing has always been super hard to tie gross CapEx to networking directly, right? Networking is still single digits of the data center spend that alone the total CapEx, right? So it’s always been hard to make direct correlations although over time, there obviously is some correlation. I think we go back to looking at the business in terms of deployment of what we’re working on with these customers, the visibility that we have. Jayshree talked about six to 12 months of visibility across the business. Anshul talked about kind of just the urgency around deployments and the need for deployments kind of in the — certainly in the near term.
So I think, that’s what we’re basing. Our kind of understanding of their businesses, and then we’ll wait and see with everybody else as to what happens after that. I think, we’re more focused on kind of what’s in front of us. And we’re fortunate that we have more visibility now, than we would normally have, because of the supply chain. So, I mean, I guess it’s a benefit from the supply chain, when you think about just being able to kind of plan the business out further. So that gives you some comfort that you understand kind of the near term and the urgency that there is around, what’s happening in that near term.
I mean the longer term, we’ll have to wait and see, where all of these guys come out and where does this recession take us and how long? And if there is a recession, how long is it, how does it impact — I mean, those things are all still, things that we’ll have to watch carefully. But right now, the dynamic in the business is still very much strong demand, constrained supply and pretty intense customer escalations, when there’s slips in — on delivery dates because of decommits and other things.
Sami Badri
Got you. One other kind of topic related to rationalization or just making changes in the way network is run is, companies like Microsoft, Amazon and Twitter. I’m not a representative of the entire tech industry, but these companies have alluded to increasing useful life of servers. How does the increase of useful life and servers potentially have any kind of relation or even have similarities to network equipment as far as useful lives, or have you seen that the network refresh dynamic is a bit more important than, say, server refreshes in the customer base?
Ita Brennan
Yes. I mean, you’ve seen those extensions of useful life on the switch side as well, right? I mean, you’ve seen Microsoft, probably twice now have extended that depreciation period from a financial perspective. And generally, that’s happening already kind of in the field before you see it kind of impact the accounting and before the accounting catches up, because the accounting will typically follow what’s happening in the business, right? So, I think we’ve lived through two of those now, particularly with Microsoft, and it’s not — it’s already happening in the field, and so it hasn’t had a dramatic kind of change to the business when we’ve seen that.
There’s always this kind of balancing act between how much — what’s the improvement on power and cooling and all these other factors, versus obviously, making a new investment from a CapEx perspective, and that’s something that they’re going to continue to — that these customers are all going to continue to evaluate.
But the evolution and the change from a technology perspective is such that they have tended to continue to refresh, right? But again, I think, we’ve seen two of those changes now and they haven’t had like a dramatic impact on the businesses.
Sami Badri
Got it. I wanted to go through your 20%-plus revenue growth CAGR through fiscal year 2025 that you guys outlined at your Analyst Day. It assumes that around in fiscal year 2024 and 2025 that there is some revenue growth deceleration. Is that the right way to kind of characterize and interpret what’s going on in the business, or is that just currently what you’re able to forecast from you’re currently standing today?
Ita Brennan
Yes. I mean, I think, we’re not trying to say we have perfect visibility to what happens in 2024 and 2025, right? I think, we have — we do think that there’s particular strength in the business right now across the board and that some of that may be — there may be some cyclicality to some of that. Exactly what that looks like, we’ll see.
I mean, the CAGR, the 20% CAGR over time, if you looked at the chart in the Analyst Day, I mean, it’s been pretty consistent, actually, five-year CAGR since we went public, right? So that 20% is kind of — it’s what the business has been delivering over time. And — so we think that’s one way to look at it.
I mean, obviously, Jayshree talked about our internal goal has been to drive double-digit growth and be able to drive a double-digit growth, right? And that’s obviously something that we’re very focused on trying to do and driving efforts that offset that cyclicality.
But, I think, our message is that, we’ve definitely seen that at least once in the past, right? And so, it’s something that everybody should be cognizant of. We’re obviously going to work to grow the pieces of the business to try and offset that as much as possible, but we may see some cyclicality. Again, it’s not that we know exactly what that number is going to be for 2024 and 2025 at this point.
Sami Badri
Got you. I want to shift gears to campus. And I know, one thing that I think a lot of investors or at least people involved in the industry were surprised to see was that, you moved away from your $400 million goal target for campus revenues in 2022. Could you go through the puts and takes on why you guys revise that down?
Ita Brennan
It’s all supply. I mean, it’s really a supply problem, right? On the demand side, we’re well ahead of tracking to that number, and it’s really just shipments and supply, right? And so, we’ll hope to kind of course correct that as we head into next year and satisfy some of that kind of untapped demand as we head into next year, but it’s just been — it’s constrained in the same way as the rest of the business has been constrained.
Sami Badri
If there was no supply chain constraints would you have expected to meet or even exceed the $400 million?
Ita Brennan
I think, we would certainly have met the $400 million.
Sami Badri
Got you. Wanted to go a little bit through something more recent that you have announced, which is the Arista’s network data lakes feature that you’ve kind of rolled out, when do you think that we will see use cases actually come out and become more materially used across the customer base using that specific feature?
Ita Brennan
Yes. I mean, we are seeing customers leverage that. And, again, it starts out with kind of just getting all of our data into a single location, leveraging CloudVision to kind of — to manage that data, but really taking all of the various data sets that we collect internally.
It starts with kind of EOS and all of the state-based data that EOS has, which is, again, pretty unique that you have the complete in-line state of the network, every switch in the network available. Then you have data that we’re collecting with some of the visibility tools, et cetera.
And then, we have customers who are looking at this and saying, okay, now I can leverage all of this data to do to manage the network, to provide visibility, provide visibility to potential problems in the network. And then they can add data from other sources to that pool of data and then use that to even expand that further, right? So we do have customers who are — I would consider them to be kind of Arista to early adopters who are looking at kind of using the data that we’re providing and then adding some other data from their other vendors.
We’re managing doing that for some customers with CloudVision, some customers are doing that themselves by just being able to access those data pools. So I think it’s still early, but you are starting to see customers understand kind of the power of just that visibility across all those data sets and particularly kind of what we’re able to provide for the network in the state of the network.
Sami Badri
Got it. Got it. I did want to talk about your free cash flow, at least projected for 2023 and 2024. Are there plans to return more capital to shareholders than form in buybacks specifically, given that your free cash flow profile is actually looking fairly attractive in 2023 and 2024?
Ita Brennan
Yeah. I mean 2022 has been an interesting year from a cash perspective because we’ve been investing quite a lot in the supply chain. And so the first question is, when do you believe that some of that starts to unravel and it comes back to what you believe about the supply chain. I think in our scenario, we were still thinking that we’re somewhat constrained from a supply chain through most of next year. So that being the case, I don’t think you’re going to see big changes in the kind of the cash flow metrics of the business in that time frame. Beyond that, whenever we get out of the supply chain, obviously, we’ll start to optimize those metrics again.
Our baseline is we’ll offset dilution and then we’ll be opportunistic about kind of returning more cash beyond that. We’ll put some more structure around that once we’re through kind of some of the supply chain kind of impacts. But if you look at year-to-date, we thought at the Analyst Day, I mean there’s a fair — we probably return more cash than we’ve generated from an operating cash flow perspective just because we’ve been funding kind of the working capital this year.
Sami Badri
Got it. We’ve seen a dynamic with other network equipment companies that involves a high degree of services revenue attached to product shipments and sales. For Arista, would you say that you guys fall kind of into a similar bucket where the reliance on shipments and services are very intertwined, or are you seeing a dynamic here where shipments or at least product revenue recognition could far outpace services revenue recognition?
Ita Brennan
I mean it will always outpace services on the — when you’re growing very quickly, right? So that’s one dynamic. I mean, when product grows really fast, services will grow at the same rate just because it’s a ratable service offering. So we’re seeing that. And then the other piece is we’re starting for the first time to see retirements from the installed base — and so that impacts renewals and the size of renewals. So that’s kind of a — so that’s a positive.
You’ve got some negative impacts that we’re still trying to make sure we fully understand. But for the first time, we’re starting to see some equipment kind of retire out of the installed base. So we’ve talked about kind of mid-teens, maybe a little bit better kind of growth rate for services until we kind of fully understand that dynamic. I think that’s a good way to model it. And then hopefully, we could do a little bit better than that. But I think in that mid-teens, maybe a little bit better is a good place to be.
Sami Badri
And then I want to shift gears to kind of other topic, which was around M&A. And you guys have done some acquisitions over the last couple of years that have kind of stood out that has like have been incremental to at least either from a staffing or from a technology perspective. But given what’s going on economically, at least in the private market and with valuations rolling down, does this make it a more conducive environment for Arista to acquire, or has it always just been very targeted and surgical in terms of what you were looking for and what you wanted to bring in?
Ita Brennan
I mean, valuations are always going to be important. And certainly, we had our views of valuations over the last while. But that’s not the only consideration. For us, a lot of the — when we look at M&A, a lot of it starts with the product teams and the technology teams and it’s more about the integration of those products, the integration of those teams, culture fit with the overall organization. And that has tended to lead us to smaller type deals, tuck-in deals with high capability, tech team sometimes known to the — through our own software team, et cetera.
So I think, certainly, we can — you could expect to see us continue to do those types of deals. I mean something bigger, larger. It just has been hard to get conviction around the success of a large acquisition versus some of the organic opportunities that we have in front of us and some of the things that we’re working on internally. So I think we’ll continue to drive hiring and continue to — if there is the opportunity to acquire a team, et cetera, we’ll continue to do that, because we still think the highest probability of success is really to execute against these markets and against really what’s within our domain of networking. There’s a lot for us to do there that if we execute successfully, I think can drive the business for a long time.
Sami Badri
And then one question really to wrap it up is as a CFO, seeing the dynamics that are playing out, what kind of keeps you up awake at night, navigating supply chains, visibility dynamics with customers? And also, I want to throw in a question around talent and hiring. So you guys have always faced a little bit of a bottleneck getting the right talent in the door, but given what’s going on in broader tech with some of the restructuring dynamics, is that making a more conducive environment for you to go out and hire the staff that you need?
Ita Brennan
Yeah. I mean, Jayshree, will tell you, I worry about everything. So I don’t think I list everything that I worry about, but I think there’s — obviously, there’s a lot of uncertainty around recessions and other things. We don’t see it in the business, but that’s obviously something that you’re going to continue to look at and take through, because we’ve all lived through prior periods. So we’re very conscious of that, and we need to look for that.
We also won’t be shy though to higher talent, because we do think it’s going to be a period — where we’ve come out of a very difficult period to hire because of the escalation in comp, et cetera. I think there is an opportunity now to be — to do — be more successful there, and we’ll do that if that presents itself.
Supply chain is — we would love to see some of the supply chain issues resolved themselves. We will need to stay very focused on kind of the how that comes back to normal lead times and managing through that. That’s something that’s top of mind for sure.
Yeah. So I think it’s more the supply dynamics. And I think our baseline assumption is that it never goes back to being quite the way it was before that we may continue to see further disruptions over time. So we’ll have to monitor that and manage that as well. So I think those are the things that are front and center. I think the demand of the business remains strong, but there’s obviously this backdrop that we need to be cognizant of and then managing supply through the solution of it and then the unwinding of those lead times and stuff is a big focus as well.
Sami Badri
Got it. Got it. Well, Ita, thank you very much for joining us today and then joining our conference. We appreciate your time.
Ita Brennan
Yeah. Thank you very much.
Sami Badri
Great.
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