Arista Networks, Inc. (NYSE:ANET) The Raymond James 2022 Technology Investors Conference December 7, 2022 10:20 AM ET
Company Participants
John McCool – Chief Platform Officer
Conference Call Participants
Simon Leopold – Raymond James
Simon Leopold
We good?
Great. Folks, thanks for joining us. My name is Simon Leopold. I’m Raymond James Data Infrastructure Analyst, here in person, live at our conference in New York. It’s nice to see people face-to-face again, it’s been a while. We’ve got with us this morning John McCool, who is with Arista, and is the Chief Platform Officer. John, thanks, good to see you. I think we saw each other not that long ago at Arista’s recent analyst meeting.
John McCool
Yes, it’s good to get together face-to-face. It’s good to see you, Simon.
Question-and-Answer Session
Q – Simon Leopold
It feels a bit odd, but it’s nice, it’s nice. So, I’ve got an outline. We’ll do sort of fireside chat, but if anybody has questions in the audience, try to get our attention. We’ll repeat questions for the webcast. I guess I want to start out with some of the high-level stuff and then drill down. But Arista provided, I think, a surprisingly good forecast for 2023, for 25% growth. Honestly, I went to the meeting with kind of a mid teens number thinking, “Okay, will probably go up to 20%.” So, 25% was a positive surprise. Maybe help unpack what sort of led into that? What are the contributors, what are the key drivers? Do you feel that’s conservative? What’s influencing essentially build-up to that model?
John McCool
Right. So, I think just starting with 2022, I think we’ve seen a good rollout of our 100, 200, 400 gig solutions in the cloud segment. And there’s clearly a cycle there that we’re participating and benefiting from that growth. We talked about, at our analyst day, not just the traditional network in the cloud but also the use cases, specifically around AI clusters. I think this is interesting; it’s been a long time since new things got connected to the network. And I had to think back to maybe IP telephony, where you had non-compute devices connected. And now we’re seeing GPUs that I think people would have thought about a closed system, maybe around InfiniBand, being connected to Ethernet. And these are large clusters that have to have a close affinity with each other to do their thing, so that’s exciting. And then I think the — we continue to drive the enterprise business with the campus offering as a new use case in the enterprise network, and that’s building momentum and gaining new customers.
Simon Leopold
And so, historically, Arista has sort of segmented the verticals. Maybe talk a little bit about what you’re expecting trend-wise from each, and how big they are, so the cloud, Cloud Titans have been the biggest. You’ve mentioned enterprise, but you’ve got some others. How do we sort of — what’s the relative contribution?
John McCool
Yes, I think about the cloud segment, that the Cloud Titans being the largest and these can be 100 times the number of servers than the next portion down, we think about the service provider and web specialty tier, which is also growing. I think we’ve seen a lot of the smaller providers and the Titans building up the same type of infrastructure, moving to 400 gig and building out their networks. And then the enterprise segment, which we’ve built that up to be a substantial size.
Simon Leopold
And when we think about the expectations for ’23 in the Cloud Titan trend, how much of this is really working down the backlog that you’ve established during ’22, in part because of supply chain constraints? And how much of this we could characterize as incremental business, what’s sort of the split?
John McCool
Yes, I think we’ve had good visibility with the increased lead time which kind of in some ways distorts the backlog metric because you have this variable time piece that makes that less of a — less clear. So, these are projects that we’ve been involved in with the 400 gig cycle, so we have good visibility into those projects and the rollout in 2023.
Simon Leopold
So, I actually received an investor question as I was walking in, that fits right here is, is it conceivable or possible that some of those cloud customers have been building up buffer stock or building up inventory? How smooth is the outlook?
John McCool
I would generalize the answer. I think, in this environment, it’s been so supply constrained that people are really chomping at the bit for deployments in what we can ship. And that continues not just around the cloud segment, but the enterprise as well.
Simon Leopold
And then one of the other sort of related debates is this question of quality of backlog. And so, it’s the idea that, yes, you have the backlog, but couldn’t it go away? How do you go about assessing that?
John McCool
I think, again, focusing more on rollouts and deployment as well as the projects we’re participating in, and getting focused on that, and when do actually people need the product. And then when can we build it and when do we get supply.
Simon Leopold
And I wanted to maybe unpack a little bit around use cases. And you mentioned one, the AI machine learning. Is that exclusive to the Cloud Titans or is that a trend that’s — you’re seeing in your large enterprise customers? And maybe what are some of the other use cases beyond that?
John McCool
Yes, I think we’ve looked at the Cloud Titans in our business as really leading the definition of new architectures. And over time, we’ve seen them apply outside of the Cloud Titans to the specialty cloud providers, as well as enterprise over time. So, if we look back, we entered routing probably five years ago, it was really the Cloud Titans that wanted to interconnect datacenters but operate them as regional datacenters as one logical network, and drove us into the routing segment. We took the routing technology and brought it into the enterprise so we could do datacenter-to-datacenter, and then ultimately to service providers. This trend, I think, is early in the cloud providers, but over time I think we would see similar kind of architecture as well in the enterprise. So, not there yet, very relevant in the Cloud Titans, but I think as an interesting use case it’ll apply across a number of verticals.
Simon Leopold
And I think if we look back, your enterprises are substantial part of your business, remind me percent, 35%-40% of revenue?
John McCool
Well, roughly as of last year…
Simon Leopold
Roughly, and then —
[Multiple Speakers] Not for specific quarter.
John McCool
Yes.
Simon Leopold
But — and given that as kind of a reference point. And I’m having this discussion with every fireside chat, aren’t we worried about a recession? Aren’t we worried about slowing from enterprises? And candidly, that the feedback I’ve gotten has been quite varied. So, I would love to sort of get your take on the recession fear and what it might mean for Arista?
John McCool
Sure. I mean I think we are clearly watching for that. Everybody is talking about it. I think in the context of the enterprise with respect to where Arista is in networking market share is pretty distorted. There has been an incumbent that has extremely large market share in the segments that we focus on which is Fortune 2000 and up.
And we come into the business really looking at differentiated offering focused on reducing operational complexity and expense. So, we have opportunities for share gain in that environment. I think somewhat independent of the overall market given where we are. Especially in Campus where we know we have been in the business for 3-4 years and they are still ramping.
Simon Leopold
And I want to get into maybe something that’s a little bit more closer to home in terms of your day to day is talking about a product cycle area. So, we often get this question about the 400 gig cycle.
John McCool
Right.
Simon Leopold
So, classically it’s where are we in that cycle? How long does it last? How is it different? And so, why don’t we start there? And then, we will kind of unpack it a little bit?
John McCool
Sure. I think 400 gig today really the market is still pretty small, but dominated by cloud, cloud titan deployments. There is definitely enterprise and some media entertainment applications. But compared to the size of the cloud titans, it’s still pretty small. We think a lot about the cycles. We have been in the networking side of the cloud for — since our inception. And, it’s only been one period of maybe a pause or a hold. And it’s tough to say whether this is cyclical or — and that what sort people think about the end of the 100 gig. It was pretty clear 400 gig technology was coming. And then, COVID hit at the same time. So, we had those two events. So, it’s difficult to find a pattern in that data, but I think we are still pretty early on this. And we talked about this cycle as 100, 200, 400 gig because the same chipsets and technology can be used across all three of those port configuration. So, we in fact have products with the same silicon architecture that have four times the 100 gig cords as the 400 gig cords. And we have customers that are deploying in all three of those flavors this new technology.
Simon Leopold
Yes, I think that’s interesting point because that’s one of the reasons I think the investment community is a little bit confused because you have been shipping 400 gig capable platforms for years.
John McCool
That’s right, that’s right, yes.
Simon Leopold
But the 400 gig optics haven’t really been readily available until maybe last year?
John McCool
Yes. And we had a customer that did some pretty big deployments at a 100 gig using that 400 gig cycle.
Simon Leopold
So, some of this may be a little bit of a nomenclature challenge for the investment community. Is that…
John McCool
There was a big break between 40 and a 100 gig. So, if you wanted to buy a 100 gig ready switch and deploy it at 40 gig, you wasted 60% of the bandwidth. So, that really pushed the market to 100 gig to take full advantage of that engine, so to speak. Here, you don’t have that inelegance. You have — you can use that same silicon for four 100s, you’re not wasting any bandwidth, and it’s a smoother migration path with this technology.
Simon Leopold
Yes. No, I feel like that point hasn’t kind of sunk in yet, so people struggle with where are we.
John McCool
And share is tracked by port speed, so that reinforces that perception.
Simon Leopold
So, the other thing that I’ve observed in this industry over multiple product cycles is disruption invite share shifts. So, when there’s a new product cycle says, “Okay, we were doing 100, we’re now doing 400,” how are you seeing that change in that your networking competitors claim that 400 is their insertion point and that they’re catching up, what are you seeing in terms of the shift in competitive landscape as product cycles change?
John McCool
Sure. I think that was a mantra a few years back before 100 gig existed. I think we feel really secure in our foothold in the early 400 gig market, and leading that market, as well as what we’ve done on 100 gig as a market leader. So, I think we’ll see what the 800 gig cycle brings, but I think we’re feeling pretty good about where we are today.
Simon Leopold
And one of the things that I thought was an interesting topic at the analyst meeting was the transit WAN.
John McCool
Yes.
Simon Leopold
So, I think there’s a lot of nuance to the different places people deploy networking gear. And so, transit WAN is relatively new.
John McCool
Correct.
Simon Leopold
So, if — let’s start out by trying to explain it to a financial audience.
John McCool
Sure.
Simon Leopold
What’s — how is this different from what you’ve done historically?
John McCool
Let me put it maybe in the context of an enterprise, some generic enterprise somewhere in the planet. You have a core network that interconnects all your buildings’ facilities. You have a datacenter that connects the servers where you run your applications; you’d have some interconnect of that backbone network to your hybrid cloud. And then the last might be connection to some type of Edge. If you were an insurance company you might have a lot of branch offices. If you were a fast food restaurant, you might have a lot of other facilities that you’re connected in. So, think about an extension of your enterprise into these smaller branch offices.
That network has had a lot of Qt technology names over time. I think in the early days of networking it was dominated by the concept of integrating services at the Edge, specifically to run voice over IP. And then we went into a period where that T1 E1 links were the bottleneck, and you had the era of WAN optimization; so, how can I optimize the links? And then, as you started to get more redundant type of networks with LTE and IP backbones, cable modems, how can I optimize those links and get as maximum bandwidth and redundancy, and you had the era of SD-WAN. So, we have the building blocks to participate in that market.
Some of those building blocks are access switches because you need them to connect when you’re in the branch. And then core routing technology to connect to the core. But what could be a differentiated solution or where could we have an impact? As you start to see hybrid cloud and the concept of transit through the cloud, that becomes an interesting insertion point for us. And we announced our intent to enter that market. But that the key piece of that is it kind of completes the picture for us of a total enterprise networking solution from the routing core, the datacenter access to the servers, the campus, and now connecting these Edge locations.
Simon Leopold
And so, it’s not that this is a new category of technology, it’s new use case for you. So, who are the incumbents in that?
John McCool
All the same incumbents we compete against today, the Cisco, the Junipers of the world, as well as some specific SD-WAN kind of startup and smaller companies.
Simon Leopold
And you’ve talked about, I guess, the amount of TAM expansion. Do you have those numbers handy, of how big that opportunity could be?
John McCool
We talked about our overall TAM growing about $10 million in the next two years, and another —
Simon Leopold
Billion?
John McCool
$10 billion over the next two years and another $10 billion after that with all of these elements all together.
Simon Leopold
And the way I’ve thought about it, and I’m okay being wrong, so just say, “Hey, Simon, you didn’t get that right.” I look at this opportunity as really being focused on more of the point-to-point datacenter interconnect for hyperscale, that this is not yet targeting sort of the typical telco metro routing applications where you’re supporting consumer broadband, and 5G, and all that other kind of stuff. So, is that in the roadmap? Do we think about you going from this datacenter interconnect use case to more of a broad, multi-service use case, is that the intention?
John McCool
This would be more of sell to the enterprise.
Simon Leopold
Right.
John McCool
So, sell to the enterprise VP of networking that runs the entire architecture, and solve the problem of how I connect my branches.
Simon Leopold
So, I want to pivot now to that enterprise campus part of that. So, in ’22, we expected revenues would double. I believe it was last quarter; you guys had to rescind the forecast, blaming supply chain. You wouldn’t have been the first, hopefully you’ll be the last, but I doubt that. What occurred really during the most recent quarter that led to the change in the forecast? What kind of parts are you suffering shortages of?
John McCool
The supply thing is more generic than just the campus piece. But given where we are, and ramping that market, I think, had a bigger impact. If I look back over the last three years, we’re out of the era of plant closures and mobility control orders that are keeping people away from work, and really impacted by the semiconductor supply chain. I think around the large devices that are typically on very advanced process nodes, things have gotten more steady. I think supply is still tight, but more predictable. But if you go to analog and power products that are used 2not just networking or even IT, they are used broadly in consumer applications. They are on 100 nanometer types of technologies and older. There has been a lack of investment in those kinds of capacity across a broad set of suppliers. And they continue to be limited, and I think we first see that happening in the 2023.
Simon Leopold
What’s your expectation for the duration of these supply chain constraints broadly because it sounds like most have said there has been some improvement? We are not out of the woods. What’s your prediction for when we are out of the woods?
John McCool
All these suppliers are working on increasing supply. They all have plans for new fabs and increasing the size of wafers to get better utilization in existing fabs. And that’s improving slowly. I think some of the demand reduction on the consumer side has actually been the primary reason that there is some benefit here. Just some context, so I think when people think about improvement, they think we are getting back to normal. Normal days worse case lead time semiconductors was roughly 24 weeks. And today, things are ranging from 50 to 70 weeks. I think we have a long time before we see going back to that old normal. There might be some new normal. And predictability would probably be the new normal as you might have extended lead times, but things show up when you expect them, and there is no surprises.
Simon Leopold
But it does appear that in general — and I am not — now stepping back broadly Arista and now Campus, that the company made a concerted effort to pay whatever brokerage fees you needed to pay to get products because you haven’t missed on revenue. Your margins have come under pressure. So, how much of that reflecting on it was intentional on your part to prioritize revenue over margin? Is that the way you think about it?
John McCool
I think we think about it in terms of fulfillment of demand. So, we saw demand. We made some purchase commitments that were significant to the supply chain in advance of this which I think what was helpful to get in line effectively. And then as you start to see missing shipments and you have the rest of the kit and you have capacity to build broker buyers are a good way to augment that to fill in those gaps. So, that’s the way we think about.
Simon Leopold
Okay. I will take you back to the Campus topic that was just my little deviation there, but Arista first announced entry into Campus, I definitely admittedly scratched my head. And I get the logic of if you have zero share, it’s one only direction to go. It’s up. And I get the idea that you have got existing customers who would be thrilled to buy other products from you because they like your data center products. So, that to me was sort of the easy part that gets you established. What takes Arista to kind of the next level from a low single digit market share player, you start facing tougher comparisons. So, whether it’s around feature differentiation or building channel, what’s the strategy to take this up somewhere substantial?
John McCool
Sure. No, I think maybe I will step back for the investors just to think about how we think about it. This enterprise network has been hyper segmented over time. As networking grew, there were number of startups that focused on different technology areas and focused on PoE and Access and focused on Wi-Fi and focused on routing. And if you are a network operator, you are consuming all these technologies. You have a different operating system. Each of those might have a different times their own security alerts. So, now have to upgrade and patch all of them separately. I have a different management network. I have to train my people across all of them. Arista has taken a different approach. We started with a data center. We added routing, but we did think in a manner with a consistent management stack and software stack. So, one EOS release that’s our operating system, will run across all these various network pieces. So, when we entered Campus I think people were looking for the knockout [indiscernible] feature, from QOS Magic or something – the magic was you could run it the exact same way as the data center. You could upgrade it the same way. And you had a consistent management profile with an extremely strong high quality operating system. That’s it. We are going to approach this transit space with that same model. So, the consistency of the environment is actually the big value add.
Simon Leopold
Now it’s interesting because everybody targets the same one big competitor who — sort of the argument is, well, the incumbent is complex, hard to do business with. And the challenges I see it is the narrative from your closer competitors in market share whether it’s Juniper, HPE Aruba, they seem to be telling a very similar story. So, everybody can sort of keep nibbling away at Cisco forever and maybe that’s a business strategy. I want to see how you think about competing in so smaller players that have a similar narrative, right? That it’s simple. It’s one screen, common management systems. How do you think about that?
John McCool
Yes. I mean it is hard to compete against the narrative because it’s very easy for me to say I have better quality, right. So, quality is an experience. Our sales teams look for an insertion point, and what we’ve given them is more opportunities to insert. When we only had datacenter, it was difficult, if you missed that refresh window you had to wait another three, four years. Well, now, you might have a campus opportunity or a transit WAN, or a management network or some way to give the customer a way to experience the Arista effect, if you will. We found if we can insert, which is probably the harder part, we’re in a really good position for the next larger win. So, you’re absolutely right, competing with the narrative is difficult, you have to get a customer to have the experience, and then we win.
Simon Leopold
And I tend to think of the Arista culture of having a certain aspect of being frugal in terms of sort of — you don’t spend money wildly, and often you’re underspending on OpEx, and struggles hiring enough people. And what I’ve struggled with is when I look at companies that are selling into the enterprise and commercial market they have to spend a lot of money on channel development, a lot of money on developing a sales force. And so far, you haven’t sort of had to go down that path, but that’s — I see it as a risk. Internally, how do you talk about striking that balance of maintaining expense control but being able to grow in those kind of markets, and given your past history, you know what it takes?
John McCool
Yes. I mean, we look in a new segment — or let’s say we have a new use case, to find that early success recipe with a handful of customers, and then we they can scale it. And then we have the confidence to go spend accordingly to make the investment. If I see some of our sales teams and how they’ve expanded in the enterprise, they found some big accounts that they’ve worked on, maybe in a region, and then gotten a toehold there, and then they bring in a partner, invest in the training of that partner specific to a region or an area. And then that partner is able to go find other accounts that are smaller and probably out of our scope of view, right?
So, that’s been the affect. I think also is that if I think about that conversation about competing against the narrative, you have to have somebody that experienced it. So, having an anchor tenant, if you will, in the region where there’s some reputational success that — and now we’ve seen people leaving companies and moving in their careers to other companies that have an Arista experience is getting easier to explain that because they can sell for us that, “It worked over here, it’ll work over there.” Five years ago, we would into account like it’s, “Who is Arista,” right?
Simon Leopold
Right.
John McCool
We had to go through explaining who we were; that’s dissipating significantly.
Simon Leopold
Now, do you see investment in the channel as an aspect of this strategy?
John McCool
Yes, that we’re using the channel to fulfill and also to deploy. So, yes, it’s critically important. But we don’t see ourselves as being kind of distribution-led, finding partners, and that model. It’s really direct driven in terms of the value and the partner coming and helping with deployment and bringing other technologies to pull it all together.
Simon Leopold
Now, the other thing I want to ask about — Oh, I’ve got a question in the back. I’ll repeat the question. But go ahead.
Unidentified Analyst
Yes, and I don’t mean to, John, drag you back into the macro world of the environment you’re in as you may have guessed from the questions been getting. But can you just tell us converting a lot of inbound questions what it is that you guys have said about the macro? You’ve obviously given your outlook for ’23. A lot of the sort of tier 2 cloud people we have here, and while the messaging varies, many of them are talking about [indiscernible] extended deal cycles, and those kinds of [indiscernible]. We’re just being asked, again, for your view. Inventory-building, I think you’ve addressed that, but just whatever the message is on the macro —
Simon Leopold
I’ll paraphrase the question for the webcast.
John McCool
Sure.
Simon Leopold
Basically —
Unidentified Analyst
— try to be longwinded.
Simon Leopold
Let’s see if I do it shorter. Basically, what’s the Arista messaging on how the macro is affecting the business broadly, beyond my earlier question about potential for inventory builds, but how are you seeing the macro play out and change?
John McCool
Yes. And let me connect that a little bit back to the distribution and resellers. And we’re very direct focused, and we’re focusing on Fortune 2000. So, we have, I think, good line of sight to actual deployments and schedules of deployments. And especially around the situation where lead times are long, maybe even more visibility and some angst around those lead times. So, that’s helpful. Look, I mean we’re definitely watching, like everyone else, the impact of macro. We’re not very retail or consumer-based in our deployments, so that helps. We’re not a bid market company. So, we might be shielded a little bit from even some of the visibility. It’s not that it couldn’t impact us if there was a deep and wide recession. But as of now, we haven’t been impacted.
Simon Leopold
So, I want to make sure I ask you about software. And so, I want to preface this with, please never call me a hardware analyst.
John McCool
Okay.
Simon Leopold
All right, and because that’s a bad word, and the funny thing is —
John McCool
You’re talking to the hardware guy, so.
Simon Leopold
Exactly, right? No, I get it. And so, part of it is, Arista is — from its roots, you don’t build your chips, you just — you have a merchant strategy.
John McCool
Yes.
Simon Leopold
So, just to — for it to help folks out, just the rough statistic, what portion of your engineering focuses on software verses hardware?
John McCool
I don’t have a crisp number, but it’s probably 90%-plus. So, it’s all about the software. And from a quality perspective, my team makes sure we don’t mess that up with the —
Simon Leopold
So, I knew the answer to that one, I just —
John McCool
Yes.
Simon Leopold
For the folks who think that networking is boxes.
John McCool
Right.
Simon Leopold
But you — Arista has taken somewhat different tactic around sort of a software strategy than some of your peers, where they talk about recurring revenue and software licensing. And you haven’t gone down that path. And maybe help us understand how you think about the software elements and monetizing them?
John McCool
Sure. Yes, I mean, we’re — we look at how customers want to consume, and what makes sense to be in a subscription or ratable model and what needs to be consumed perpetual. It is very clear that the expectation of the market is when we sell a box, that it comes with an operating system, and that operating system has a perpetual license. We sell services that allow for upgrades and whatnot through — and service and support, that that’s a component of that. But that model is widely accepted, and I think that that’s what people want. Not really a model where they want to look at over three years that I use a certain feature and then I upgrade my license for that new technology.
They — that we do sell like routing licenses for high-end routing features and applications and drive an additional revenue on top of that, and that’s well received. But we have Wi-Fi licenses that are on a monthly basis because that runs in the cloud, and it’s connected with service. So where it makes sense we’re going to monetize, where the consumption is appreciated by the customer we’ll do that. But if it’s something around the box and what runs and what comes out of the box and — we also want to simplify that licensing experience. So, we’ve seen a lot of operational complexity of people not being able to run the networks because they don’t know what features they use or what box has what license, it’s very —
Simon Leopold
Easy to be in business with.
John McCool
It’s very important that it’s easy to consume, yes.
Simon Leopold
Great. So, we’ve actually pretty much run out of time. So, this was fun, it went by quickly. I like to close with one question that, given the discussions you’ve had with investors recently, you have an opportunity to maybe try to expose something you think is either underappreciated or misunderstood that maybe we didn’t get into but how would you like to sum that up?
John McCool
Yes, I think I’ll just reinforce a point we talked about here on the enterprise side, where we talked about the different pieces and the WAN transit, and the campus. I think it’s important to think about how we position ourselves as an enterprise networking company, and an alternate, and really on a different competitive vector around the operational ease of use, and think about the enterprise business in that light.
Simon Leopold
Well, great. Well, folks, thanks for joining us. John —
John McCool
Thanks for having us.
Simon Leopold
Thank you very much.
John McCool
Great to see you.
Simon Leopold
Pleasure. This is Simon Leopold wrapping up with Arista and John McCool. Thanks.
John McCool
Okay.
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