Arista Networks, Inc. (NYSE:ANET) Q1 2023 Earnings Call Transcript

Arista Networks, Inc. (NYSE:ANET) Q1 2023 Earnings Call Transcript May 1, 2023

Arista Networks, Inc. beats earnings expectations. Reported EPS is $1.43, expectations were $1.34.

Operator: Welcome to the First Quarter 2023 Arista Networks Financial Results Earnings Conference Call. As a reminder, this conference is being recorded and will be available for replay from the Investor Relations section at the Arista website following this call. Ms. Liz Stine, Arista’s Director of Investor Relations, you may begin.

Liz Stine: Thank you, operator. Good afternoon, everyone and thank you for joining us. With me on today’s call are Jayshree Ullal, Arista Networks’ President and Chief Executive Officer; and Ita Brennan, Arista’s Chief Financial Officer. This afternoon, Arista Networks issued a press release announcing the results for its fiscal first quarter ending March 31, 2023. If you would like a copy of this release, you can access it online at our website. During the course of this conference call, Arista Networks management will make forward-looking statements, including those relating to our financial outlook for the second quarter of the 2023 fiscal year, longer-term financial outlook for 2023 and beyond, our total addressable market and strategy for addressing these market opportunities, including AI, customer demand trends, supply chain constraints, component costs, manufacturing output, inventory management and inflationary pressures on our business, lead times, product innovation, working capital optimization, and the benefits of acquisitions, which are subject to the risks and uncertainties that we discussed in detail in our documents filed with the SEC, specifically in our most recent Form 10-Q and Form 10-K and which could cause actual results to differ materially from those anticipated by these statements.

These forward-looking statements apply as of today and you should not rely on them as representing our views in the future. We undertake no obligation to update these statements after this call. Also, please note that certain financial measures we use on this call are expressed on a non-GAAP basis and have been adjusted to exclude certain charges. We have provided reconciliations of these non-GAAP financial measures to GAAP financial measures in our earnings press release. With that, I will turn the call over to Jayshree.

Jayshree Ullal: Thank you, Liz, and happy Monday, everyone, and a happy month of May. We delivered revenues of 1.35 billion for the quarter with a non-GAAP earnings per share of $1.43. Services and software support renewals contributed approximately 13.5% of the revenue. Our non-GAAP gross margins of 60.3% was influenced by supply chain overheads and cloud titan concentration. We expect our gross margins to improve every quarter throughout this year. International contribution registered at 17.5% with the Americas strong at 82.5% for the quarter. While we will shift to reporting our vertical segments on an annual basis, I would like to share some overall trends we’re seeing. We do expect cloud titans will moderate compared to our 2022 triple digit growth, while enterprise is likely to be more steady state.

It is evident that our lead times are improving. Our visibility to customer forecast therefore are now beyond six months or now below six months, I should say, and they are shrinking. Despite macro uncertainty, we endorsed consensus of 26% annual growth to approximately 5.5 billion revenue in 2023. On the product side, we made many exciting Q1 announcements. At OFC 2023, we introduced our vision for Linear Drive Optics for intra and intra-datacenter connectivity at 800 gig and beyond. This was a highlight for both Arista and the optical industry at large, delivering the promise of low power and improved price performance for demanding AI workloads. Speaking of AI, the mandate to avoid idle states in expensive and large AI processor clusters requires that specialized AI network.

Key characteristics include wire rate and lossless delivery of large and synchronized bursts of data at 400 to 800 gig speeds. Today, the combination of RDMA mix, RDMA stands for remote direct memory access; and ROCE, which is RDMA over converged Ethernet along with the switches, allows Ethernet to become that predictable transport network. Ethernet of course brings familiarity, great economics, massive install base, standards with industry-wide interoperability, and many merchant silicon options. This is supporting compute and data intensive workloads based on generative AI, inference, and large language model training applications. Arista’s cloud customers are resonating with our AI and switching strategy for platforms. Presently, we are in the midst of trials leading to production deployments this year in 2023.

We expect AI networking to become meaningful throughout the years and through the decade ahead. In Q1 2023, Arista also formalized our new entry into the wide area network with our WAN routing system. Our enterprise class routing platform is based on carrier and cloud neutral transit with CloudVision Pathfinder Service. Not surprisingly, we support Arista’s EOS operating system stack, delivering that operational model for network as a service and wide area as a service. We are targeting mission critical enterprises where and encrypted traffic matter in a modern WAN. Arista has partnered with Equinix to develop and deploy the WAN routing system and WAN routing will be included as part of our network adjacency category. In the non-cloud category, we have registered a solid number of million dollar customers, which is a direct result of our momentum in the enterprise and campus throughout the past year.

Let me illustrate with a few customer wins. The first used case is an international government win. The customer’s objective was to detect illegal activities such as money laundering, terrorism, scams, and other criminal behavior in real time by collecting and analyzing data. Arista’s data-driven AI clusters are optimizes network assurance for mission critical AI and ML workloads. Using advanced features like microburst and fan in congestion management, ultra deep packet buffer memory with latency analyzer provides real time telemetry, visibility, automation, and dynamic controls for their AI and ML data centers all based on open standards Ethernet. Our second win continues on the international theme and highlights our ever growing strength in the education vertical, where Arista’s proposal for Edge Campus platforms ranging from power over Ethernet switches, wireless access points, and automation was a decision factor.

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We leveraged , cognitive unified edge, coupled with Arista validated designs as an automation framework across multiple distributed locations bringing unmatched flow visibility. The next win is in the U.S. Financial sector. This customer had grown organic and inorganically through acquisitions and is looking to modernize their entire infrastructure, moving their data closer to the cloud to enable a hybrid cloud architecture. This design included multiple greenfield data centers, hosted in Equinix, requiring active-active 400 gigabit Ethernet fine, securely encrypted data center interconnect and Internet connectivity at each site. For a smooth upgrade in their campus environment without disruption to their end users, Arista’s SSU or smart systems upgrade feature played a prominent role.

We also help them build a digital twin of their environment modeling their designs for automation. The next customer highlights healthcare as a critical win for network monitoring and security analysis tools at their remote data center facilities. This holistic view of Port Mirroring sessions for traffic analysis from all their remote data centers was a superior approach. Arista’s centralized DMS, DANZ Monitoring Fabric was better than disparate and expensive tools at each remote location. A final customer win was looking for real-time in-house video streaming and editing capabilities. Video would be stored on their storage arrays, which could be connected at 100 gigabit Ethernet and then accessed and rendered by the clients, be they PCs or Max with 25 gigabit Ethernet.

Arista’s core strength in the media vertical comes from its deep buffer virtual output queuing architecture with our R3 platforms. The simplicity, scalability, and flexibility aligns this – shows this elegant design and highlights our strength in the media and entertainment vertical. So, as you can see, this is a recurring theme in all our customer wins, where Arista is deploying innovative solutions based on a consistent architecture, allowing each and every customer to modernize their network with the power of our platform. And with that, I’d like to hand to Ita, our CFO for financial metrics.

Ita Brennan: Thanks, Jayshree, and good afternoon. This analysis of our Q1 results and our guidance Q2 2023 is based on non-GAAP, excludes all non-cash stock-based compensation impacts, certain acquisition-related charges, and other non-recurring items. A full reconciliation of our selected GAAP to non-GAAP results is provided in our earnings release. Total revenues in Q1 were 1.351 billion, up 54% year-over-year and well above the upper end of our guidance of 1.275 billion to 1.325 billion. We continue to experience improvements in component supply in the quarter, supporting more consistent levels of manufacturing output and some improvements in lead time. Services and subscription software contributed approximately 13.5% of revenues for the first quarter, down from 15.8% in Q4.

It’s largely reflected accelerated growth in product revenues, while services and software continue to grow on a more consistent basis. International revenues for the quarter came in at 236 million or 17.5% of total revenue, down from 23.5% last quarter. This quarter report a reduction, largely reflected on unusually high contribution from our EMEA and region customers in the fourth quarter. Overall, we continue to see outsized growth in the U.S. largely due to ongoing domestic strength of our cloud type and customer. Overall gross margin in Q1 was 60.3% in-line with our guidance of approximately 60%. We continue to recognize incremental supply chain costs in the period, combined with the healthy cloud mix. Operating expenses for the quarter were 257.5 million or 19.1% of revenue, up from last quarter at 235.3 million.

R&D spending came in at 164.8 million or 12.2% of revenue, up from 153.2 million last quarter. This primarily reflected increased headcount and new product introduction cost in the period. Sales and marketing expense was 75.9 million or 5.6% of revenue, compared to 67.4 million last quarter with increased headcount costs and higher variable compensation expenses. Our G&A costs came in at 16.8 million or 1.2% of revenue consistent with last quarter. Our operating income for the quarter was 556.8 million or 41.2% of revenue. Other income and expense for the quarter was a favorable 17.7 million and our effective tax rate was 21.2%. This resulted in net income for the quarter of 452.5 million, a 33.5% of revenue. Our diluted share number was 315.6 million shares, resulting in a diluted earnings per share number for the quarter of $1.43, up 70% from the prior year.

Now, turning to the balance sheet. Cash, cash equivalents, and investments ended the quarter at approximately 3.33 billion. In the quarter, we repurchased $82.3 million of our common stock at an average price of $111.9 per share. We’ve now repurchased $825.5 million or 7.8 million shares at an average price of $106 per share under our current billion dollars board authorization. This leaves 174.5 million available to repurchase in future quarters. The actual timing and amount of future repurchases will be dependent on market and business conditions, stock price, and other factors. Now turning to operating cash flow for the first quarter. We generated approximately of cash from operations in the period, reflecting strong earnings performance, partially offset by ongoing investments in working capital.

DSOs committed 57 days down from 67 days in Q4, reflecting a strong collections quarter with good linearity of billings. Inventory turns were 1.3x down from 1.6x last quarter. Inventory increased to 1.7 billion in the quarter, up from 1.3 billion in the prior period, reflecting the receipt of components from our purchase commitments and a slight increase in switch related finished goods. Our purchase commitment at the end of the quarter were 2.9 billion, down from 3.7 billion at the end of Q4. We expect this number to continue to decline in future quarters as component lead times improve and we work to optimize our supply positions. Our total deferred revenue balance was 1.092 billion, up from 104 billion in Q4. The majority of the deferred revenue balance and services related and directly linked to the timing and term of service contracts, which can vary on a quarter-by-quarter basis.

Our product deferred revenue balance was flat to last quarter. Accounts payable days were 55 days, up from 43 days in Q4 protecting the timing of inventory receipts and payments. Capital expenditures for the quarter were 5.6 million. Now, turning to our outlook for the second quarter and beyond. As we move through 2023, we expect to resolve the final the supply chain, allowing for more consistent manufacturing output and improving lead times to our customers. We do however expect these reduced lead times to also result in reduced visibility. The customers no longer needing to make purchase decisions so far in advance of deployment. In addition, we expect some moderation in customer spending, especially with our cloud titan customers following year of accelerated demand in 2022.

All of that being said, we believe customer engagements and current deployments across business support the current consensus revenue growth rate for 2023 of approximately 26%. In terms of quarterly trends, you should expect moderating year-over-year growth as the year progresses with more difficult prior year comps. On the gross margin front, beginning in Q2, we expect to see some steady improvement as we consume fewer broker parts and have the opportunity to optimize manufacturing output, while maintaining a healthy contribution from our cloud customers. Now, turning to spending and investments, we continue to monitor the overall maximum environment carefully will prioritize our investments as we move through the year. This would include a focus on targeted hires and R&D and go to market as the team sees the opportunity to acquire talent.

On the cash front, I will continue to focus on supply chain and working capital optimization. We should expect some continued growth in inventory on a quarter-by-quarter basis as we receive components from our purchase commitments. With all of this in the backdrop, our guidance of the second quarter is based on non-GAAP results and excludes any non-cash stock-based compensation impacts and other non- recurring items is as follows: revenues of approximately 1.35 billion to 1.40 billion; gross margin of approximately 61%, operating margin at approximately 40%. Our effective tax rate is expected to be approximately 21.5% with diluted shares of approximately 317 million shares. I will now turn the call back to Liz. Liz?

Liz Stine: Thank you, Ita. We will now move to the Q&A portion of the Arista earnings call. To allow for greater participation, I’d like to request that everyone please limit themselves to a single question. Thank you for your understanding. Operator, take it away.

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Q&A Session

Operator: Your first question comes from the line of Aaron Rakers with Wells Fargo. Your line is now open.

Aaron Rakers: Yes, thanks for taking the question. I’m just curious, kind of the commentary around the hyperscale cloud as component lead times shrink, how would you characterize if at all, you know the visibility in that vertical? And specifically how maybe that’s evolved or changed relative to let’s say the commentary or the thoughts a quarter ago? Thank you.

Jayshree Ullal: Yeah. Hey, Aaron. I’ll kick it off, and maybe Anshul can help me. As you know, historically visibility with the cloud titans issue, if you take out – if you subtract the last two years, which were largely supply chain related, was typically two quarters, right? And for a period of time last year and the year before, we were starting to get four quarters of visibility. As our lead times are improving, our visibility is also shrinking, especially with that segment because they can make decisions closer to our lead times. So, I would say our visibility has reduced from last year to this year by two quarters and is roughly six months.

Liz Stine: Thank you, Aaron. We can go ahead and take the next question.

Operator: Your next question comes from the line of Antoine Chkaiban with New Street Research. Your line is open.

Antoine Chkaiban: Hi. Thank you very much for taking my question. So, at the CMZ, I think you provided an AI intensive network stand of 2 billion, 3 billion in the next few years. And during last earnings, said that their Ethernet switch chips deployed in AI was well over 200 million in 2022 and did forecast that this could grow to well over 800 million in 2023. So, I imagine that that would correspond to 4 billion or 5 billion in revenues. This is therefore already well above the that you estimated. Am I missing anything or did the TAM expand considerably more than you are anticipating at the CMD?

Anshul Sadana: Sure. Hi, this is Anshul. As you know, there’s a lot of talk about AI and it’s a very exciting topic in many ways. First, you have to separate out numbers that Broadcom’s giving you versus where our customers will deploy systems, right? There’s an offset of when they ship chips versus when they can ship systems and often by a quarter sometimes as long as a year, right, given the lead times and so on that are going on in the market. Second, I think AI is still in its infancy. I don’t think we know really how big it will be. It’s clearly on a very good trajectory to keep on growing. And there is a great opportunity for us for sure and we’re doing very well with some of our top customers as Jayshree talked about in the primary script as well.

Jayshree Ullal: Yes. And just to add to what Anshul said, our forecast of 2 billion to 3 billion is more in the 2025 arena. Market analysts are already showing larger numbers than that, 2025 to 2027 arena. I think market analysts are already projecting it’s double that. And certainly Broadcom is enthusiastically looking at their chip deployments. But again, as Anshul alluded, by the time Broadcom has a chip, the chip gets built into a system by us, and then the system gets deployed by our cloud customers. It can be 1 to 2 years.