Arista Networks, Inc. (ANET) Earnings Call Transcript & Summary

Hello. It's great to see everyone virtually. I'm Jim Suva, the IT hardware and technology supply chain as well as telecom equipment analyst here at Citigroup, where we're hosting our Global Tech Conference virtually due to COVID. This session is a fireside chat with myself and Arista Networks, stock ticker ANET. A couple of housekeeping items. First of all, no media and no press are allowed. If you're media or press, please disconnect immediately. Also, if you're an investor subject to MiFID II, ensure you have those agreements in place. We do note there are disclosures associated with this at the Citigroup philosophy as well as the log-in websites as well as been disseminated. And I do want to ask you to please take a look at the Arista Networks Investor Relations website, where they have a safe harbor, risks and forward-looking statements for you to review. This is meant to be pretty interactive. We have prepared questions ahead of time. But I want to introduce Ita Brennan. Ita is the Chief Financial Officer at Arista. [Operator Instructions] We are not opening up lines because we know there are a lot of people connected, and we want to ensure the video and audio high quality.

So Ita, thank you so much for joining us today as Chief Financial Officer. And can we start off by talking big picture? Arista has reported 3 quarters in a row, 3 of very impressive growth. And this is despite the pandemic. Can you talk about that and the sustainability, and just kind of give us an overview of those?

Yes. No, I think we've come through this year with an improving trajectory and return to growth as we've gone kind of quarter-by-quarter. I think the good thing about it and the exciting thing about it is that it's been across the business. We've seen good growth contributors across the various pieces of the business. And if we kind of get through those, we've seen cloud and our cloud business kind of return to strength. We're seeing healthy demand there. And now it's more of a supply constraint and managing supply constraints that are really shaping that business. We've seen continued strength in the enterprise and campus businesses. Those businesses have been growing very healthily for a number of years now. They contribute to do that -- continue to do that. We're seeing good win rates, improved win rates there across that enterprise business. So that's exciting. And the consistency of that, I think, is important from an overall business perspective. And then in terms of the other providers businesses, we've also seen a return to growth there. So good strength across the business. Part of it is -- some of it is product cycle-related on the cloud side as we enter into some of these new products. And some of it is just continued execution against what has been a very nice, consistent growth rate across some of the enterprise and other pieces of the business.

You had mentioned component costs or chip shortages. As CFO, can you talk a little bit about that and kind of the supply chain challenges?

Yes. I think, look, this is probably -- it's -- unprecedented is a word that gets used a lot, maybe overused. But I mean, I think this is a very interesting supply environment that we're navigating right now. There are some real choke points in the supply chain, particularly around some key components like semiconductors, et cetera, that will take time to be alleviated just because you can't add capacity in a short time frame, right? So I think obviously, there are investments being made to kind of to alleviate some of this, but we do believe that it's going to take some time. That results in, obviously, a constrained environment, some increased costs, some expedite fees, et cetera, that have to be paid. And we think we'll continue to navigate that probably for some time, certainly into next year or maybe even into the beginning of 2023. How are we dealing with that? We've taken some positions -- we took some positions early in terms of supply in anticipation. That has helped. We are seeing some impacts. We've talked about looking to pass on significant impacts that are kind of sustained to customers. So we'll look to do that over time. I think customers understand what those costs are and are responsive to that. But it really is -- it's just a ton of work that's going into kind of managing different elements of supply. It's not always the key component. Sometimes, it's more of the commodity components, et cetera and making sure that we're kind of managing through that and that we're able to respond to that. So you'll see us make investments in terms of purchase commitments. We're fortunate that these are new products in a lot of cases, so we can make those investments early and have less concern about obsolescence, et cetera, later on because we've got the full life cycle ahead of us. So we'll continue to do that. You'll continue to see us do that. And we'll manage the cost impacts as best we can. And if they are significant, we'll look to pass some of those on to customers.

You and I, we both live in the Bay Area, and the shipping docks are packed. And in fact, if you look out, you see many of them anchored waiting to come in to be unloaded. So it seems like the shipping costs have really come up. You talked about lead times and stuff. But yet, importantly, your margins have been improving. So we talk about challenges and headwinds. How can I square all these challenges and headwinds, yet your profitability has been improving?

Yes. I think you have to go back to the overall kind of structure of the business. And we've always talked for a long time now about the fact that the biggest driver of gross margin volatility for us will be customer mix that we have. We have high volumes, large customers who have higher discounts, therefore, lower gross margins. We have smaller kind of customers where there's more software content, there's more service content, et cetera, that will have a higher gross margin profile. So the mix of the business is an important driver of gross margins in any particular time frame. And particularly, if you look at last quarter as a good example, we had a heavy enterprise mix in that quarter. So that's obviously a positive driver of gross margin, and masked, to some extent, some of the cost impacts that we were seeing on the supply chain side. I think the other thing to remember is as we have these extended kind of purchase commitments in place, the costs will flow through the P&L in the time period in which you actually revenue and sell those particular components. So there is going to be some time matching that will happen in terms of when those cost structures show up, right? So we made some early actions that are probably driving our cost structure today. We will see some flow through of some of those costs that we're committing now in future periods. Again, we'll look to mitigate the significant elements of that by passing some on to customers. But net-net, I think we can stay in that 63% to 65% because of that. But there is going to be some time matching of those cost increases that happens where you'll see those kind of flow through as we consume the components that we're ordering with those costs now.

So 63% to 65% seems like a good calibration, even though recently, you've kind of been above 65% this most recent quarter because you're saying the timing of the layering in of some of this is going to be coming, say, in the second half of this calendar year?

And even into next year, making sure that this is a this year conversation. And I think layered on top of that will be certain quarters where you'll have a heavier maybe cloud mix as well, right? So I think on a quarter-by-quarter basis, you'll see more volatility. I think over time, we can stay in that 63% to 65% range.

Okay. And you mentioned mix is really important to impact your profitability. Maybe without going into details of exactly what the mix is as far as gross margins, or at least can you rank order a couple of the ones that are -- I'm sure, software and services and security higher. But can you kind of help people know. I think if I remember right, you have about 5 segments such as enterprise and cloud. Which ones are the most gross margin-positive? And which ones are kind of a little bit subdued? Just so we can kind of think about those future trends.

Yes. I mean, I think the interesting thing is that at an operating margin level, they all still perform well, right? And they're pretty consistent actually across -- it's really a trade-off between kind of gross margin and just high volume, larger customers, and then less sales and marketing investment. And then you look at kind of an enterprise piece of the business where you have a smaller kind of volume sale, but then more sales and marketing investments. So I think the -- I don't know that we've put specifics on it, but if you think about the size and scale of the customers, that will give you some idea. Higher volume will generally earn higher discounts. Lower volumes will tend to have a lower discount structure. So if you think about our cloud business, that's obviously where most of the volume is. The largest volumes are that will have a lower gross margin, but then a very low sales and marketing investment as well, giving us a healthy operating margin still. In the enterprise space, maybe there's a higher gross margin, but we're spending -- most of our sales and marketing investment is directed towards that piece of the business, bringing you back to an operating margin that's not dissimilar to cloud.

And Ita, I've been covering Arista for a long time and I've known you for a very long time also. I do think back a little bit and think about your services and software. It has really grown to be a much more meaningful part of the company. Can you spend a few minutes talking about that growth? Was it organic? Was it acquisitive? And are we at the point where it's mature now? Or is that still going to continue to evolve to be a bigger part of the company?

Yes. I mean, a big piece of that is the services, software support piece of the business, right? And that's what we call A-Care. We have a very, very high attach rate on that services software support line. 90-plus percent of the switches that are in -- that are live in customers' networks are under support, right? I think that just speaks to the quality of the software support, et cetera, that the team is providing. So what you've seen over time, obviously, as you continue to sell, you have an attach rate on the current period product sales, but you also have an attach rate on the install base and the renewals of those installed base. And that has caused that kind of growth in that services contribution over time. So it's a very nice recurring revenue stream with good gross margins. I think it continues to grow as a percentage of revenue for some time. Eventually, you'll start to retire some stuff out of the installed base, and that's at the time when maybe kind of that growth as a percentage of revenue starts to kind of flatten out. But we haven't quite hit that in any kind of meaningful way yet and won't kind of in the near term. But eventually, that's what will cause that -- will probably cause that percentage of services revenue to start to flatten out. I think on the software side, we're very focused on software and add-on software features that we can sell to customers that are valuable to enterprise customers and not kind of trying to separate the operating system itself, but more looking at where can we add on capabilities. So it's kind of the -- it's a big switch, monitoring capabilities now that they've been incorporated into Arista. It's the flex license for routing. It's the Awake software capabilities. And that is -- that's becoming a more meaningful piece of the business, but it is a ratable revenue model. So as a percentage of revenue, it's still pretty small, but it is growing. It is growing healthily. But relative to the whole, it's still pretty small.

I think it would be fair to conclude that Arista has been gaining not a little bit, but quite a bit of share in the marketplace out there. Is your intelligence telling you that you're gaining share from the incumbents? Or for a while, white boxes was gaining a lot of share. Is it accurate that both you and white boxes are gaining share? Do you view white box as a competitor? If you can just maybe talk about the landscape of the competitive environment, that would be great.

Yes. We updated our investor deck to kind of show the market share charts, et cetera, for the first half of this year just now, so you can see that in our investor side. But we have continued to take share in the first half of this year, which is obviously great and positive to see. I think it comes back to -- we're doing well kind of across the business. And we've been executing very consistently on the enterprise side in terms of adding new customers and being relevant in customers where we haven't played before. So I think we are continuing to take share there. And on the cloud side, we've definitely seen this recovery of spend. And again, I think we're executing well and taking our fair share of that too, right? If you look at -- our 100 gig market share is still -- we're still leading in that? Is it at the expense of white box? I think that there's been some distortion in kind of looking at 400 gig and stuff so far because it's been driven by the architectures of the individual customer. So you've seen white box have a significant share number in 400 gig early on. But that's just because the other customers hadn't quite gotten to that form factor yet. So that's been a little confusing. I think we like to amalgamate the whole thing and say look at 100, 200 and 400 together. And I think we're pretty happy with how our share is playing out there when you look at it as a combined group, because some customers are adopting 400 gig, some are adopting a 200-gig configuration, some are still deploying 100-gig configuration. But if you put all that together, I think we're pretty happy with how our share is playing out there.

And then when Jayshree, your Chief Executive Officer, talks about investments, can you help shed some light about what does she mean by investments? Is this sales staff ramping? Is this going into the campus side? Or help us understand what type of investments should we be thinking of? Because you would think when you kind of plant those investments, at some point, the fruit is really going to start to ripen and maybe we're starting to see that? Or what can we look forward to from those investments?

Yes. I mean I think the investments are across the business, right? We came into this year saying that we're willing to spend operating OpEx at a faster rate than revenue if that's what we needed to do. Now with the growth rates that we've seen, turned out we didn't need to do that. But what were those investments? We were looking to invest in the R&D line. I mean we are -- if you think about it, we are broadening the portfolio all the time. We're seeding new markets effectively with campus and, to some degree, routing, and we're continuing to kind of add functionality for that routing piece of the business. And we need to continue to grow the R&D teams to support that. So that's still -- Arista is a company that's very focused on the product set. And so that's still key, is that we're able to continue to expand the software teams and expand the investment on the R&D side. And then obviously, sales and marketing. We've been growing the sales team roughly 30%, plus or minus, for a number of years now. We'll continue to do that. We are making some investments in the channel. I mean, again, it has to be targeted just because of the dynamics of the market. But we are investing in partners, finding partners that we can build a channel strategy with, particularly to support campus as we go forward. So we're continuing to do that. You've seen us do some of the M&A acquisitions for features and adjacencies that make a lot of sense. I think we'll continue to look at that as well. But I think that's the -- that's kind of the landscape. So it's really investing to support kind of the continued execution of the business, whether it's R&D and the expansion of that or its go-to-market.

You didn't mention acquisitions much. How should we think about acquisitions? Are they really important? Are they key? Are they bolt-on or big transformational acquisitions?

Yes. I think we believe that when you look at -- and you can look at the TAM slide in the investor deck, there's a lot of opportunity in front of us kind of within our core business, right, whether that's continuing to add evolution or ultimately open a service provider and some of the other pieces of the business as well. So we believe there's a lot to be done organically. We need to make those investments and stay focused on that. And the role that M&A has been playing, which you've seen, is really looking at feature sets and capabilities that are adjacent that we can add to that overall product offering. And I think that's likely to be the way that it continues to play out, not that we wouldn't look at something bigger if there was real conviction around it. But so far, I think the focus has been continue the organic evolution and then look for adjacencies that makes sense around that.

And as investors, sometimes, people look at different metrics that companies provide. One metric you provide is deferred revenues. Can you talk about that to investors, about what is in deferred revenues? Is it important? Is it a lagging or a leading indicator? Should be stable or volatility? Just the topic deferred revenues would be great to talk about.

Yes. I think in a steady state kind of environment, which if you look back over the last couple of years, deferred revenue has been largely services related, right? And it's the deferred revenue associated with the services contracts that we build, but we still have to execute against providing some of those services. We do, from time to time, when there's a -- when there are new product cycles and new customer engagements, see product deferred revenue as well. And that's a situation where you either have a new product or a new use case or a new customer where you're delivering something that hasn't been proven out in their environment previously. And there's some complexity around it and the customer wants to see that executing that deployed in their environment before they give you file and complete acceptance of the product, right? So they're not waiting to -- they're not trying to do qualifications upfront. They are willing to kind of have you transact the business, but they're requiring an acceptance criteria to make sure that everything works in their environment before they'll give you final acceptance. And that gets captured in deferred revenue. That's this product deferred revenue that we'll talk about, which tends to build with these new product cycles or new use cases. And then once those products have been proven out in the marketplace, will start to decline again at some point in the future. Right now, we're in a build phase of that. We've seen -- we've incremented deferred revenue in 2 quarters in a row now. There is a lot of new product activity around. So we'll see how that plays out. I'm not trying to forecast that at this point. But there is a lot of new product, new customer, new use case activity, which typically will cause there to be product deferred revenue on the balance sheet.

Okay. Speaking of a little bit of volatility, your capital expenditures have a little bit of a bump up. I think you're going through some expenditures in Santa Clara, which is just down the street from where you and I live. Can you walk through investors about what's going on there? Is that R&D? Is that your headquarters relocation? Is there a lot more future build out there? Or is it a data center? Or what should we think about for the CapEx and what's going on there?

Yes. It's really looking at kind of our data center footprint, which is a lot of that is related to kind of just the software itself and the testing and qualification of the software itself. And kind of other testing activities that we have that involves either a hardware or lab space, et cetera, et cetera. So we're looking to kind of consolidate all of those into a single location that we control and own and that we don't -- we're not facing kind of lease changes, et cetera, but something that we can control and own. So we made the investment on the -- which is largely for the land in the last quarter. Now we're working -- we'll put together a plan for how we deploy a facility and all of the costs that go along with that. But our ROI says there's a good ROI in terms of us doing that ourselves and controlling that ourselves versus having it outsourced to different vendors, et cetera. So that's really what that is. It's more just an optimization, I think, of control in terms of being able to control our own destiny around that stuff. It's the type of thing that you don't want to move frequently. And then there's also a good return on investment from a cost structure perspective, if we put a program around that.

You mentioned earlier in our discussion that you've been growing your sales force pretty aggressively for the past several years. Do you -- is there a need you have to build out more CapEx buildings to house them or train them? Or has COVID kind of changed that things are more virtual. Now what I'm trying to get at is, what's a good CapEx, I guess, reasonable way to think about things as people model cash flow and CapEx for your company?

Yes. I mean our -- if you put this kind of investment in the data center side aside for a second, I mean our CapEx has been running in that kind of $5 million to $10 million a quarter, usually closer to the lower end forever, right? So it's not a high capital-intensive business, right? All of our manufacturing is outsourced. So really, it's around kind of testing, and the data center infrastructure is kind of where we spend CapEx. For the sales team, we've always -- like long before COVID-19, we've always believed that having salespeople in the field with customers -- actively with customers was a better approach than having kind of salespeople located in offices, et cetera. So we've had a relatively light sales and marketing building lease structure in any case. And I think COVID has just confirmed that, right, that really it's virtual or it's at customer sites and we want salespeople in the field spending time with customers, et cetera. So that's never been a huge investment for us. And COVID, I think, has just confirmed that, if you like, that there is a model that works without kind of that large real estate investment. So I think it's -- aside from the building, it's very much kind of steady state. Manufacturing is outsourced. It doesn't drive a big CapEx cost. And really, the building, we'll come back to you with kind of a project plan for the building, but that's probably where we'll spend some CapEx over the next couple of quarters.

And Ita, as Chief Financial Officer, you're dubbed with the responsibility for capital allocation. I get asked, "Hey, would Arista announce a dividend?" I'm like, well, they're growing so much, it's probably a better use of funds to continue to support the business for organic growth. But then I believe, if I remember, you've got a pretty sizable authorization for stock buyback ballparked around $240 million or so. As Chief Financial Officer, can you kind of give us some thoughts on capital allocation and prioritization and use of capital?

Yes. I think you're right. The priority is invest in the business, right? And that we have the luxury that we can do that and probably consider some other investments as well, but that is the focus, right? So do make the investments that we've talked about already. I mean, right now, honestly, investments of cash and the use of cash is around the supply chain as well. It's leveraging that to be able to ensure that we get our fair share of the supply that is available. And you'll see us kind of make some pretty significant purchase commitments, et cetera, against that. And it's great to have the balance sheet and the capabilities to do that, right? After that, I think we will look at M&A. But like we talked about, it's probably more adjacency-type investments. But again, if there's something there that really makes sense, that the team is excited about, we want to reserve the right to be able to do that. And then finally, we will return cash and we are returning cash. We had $1 billion authorization, and we have about $200-and-something million left on that authorization. So we'll continue to execute against that, and then look at where we go from there with the Board, et cetera, on a future authorization. So I think that's the hierarchy of kind of priorities, with the business being obviously, #1.

And some CFOs, Chief Financial Officers, view the stock buybacks to materially reduce the shares outstanding. And others view it as let's just at least offset stock options and compensation for employees that come through. As CFO, your stock buyback, which framework do you take about? Materially reducing the shares outstanding? Or more just offsetting the dilution that comes with vesting of time?

I think we're pretty frugal in terms of how we think about our stock, and we treat our shares and our stock compensation similar to how we treat cash in terms of how we spend that. So we have -- I think we have a pretty disciplined approach to that. And the buybacks that we've been doing have been more than offsetting that, if you look at it over time. I'm not sure we're taking that complete, but that's a strategy, if you like. I think we look at the buybacks more as, again, where does it make sense when you think about those other priorities? And when does it make sense to execute against that. But I think if you look historically, we've been probably more than offsetting kind of the dilution partly because we have a pretty disciplined approach towards the equity grants.

I got e-mailed the question from a couple of people asking about -- many companies have complained and have not been able to the upside due to supply constraints, semiconductor shortages or whatever, but Arista has been able to upside. How come you guys could get the products and parts and finish your goods and get it out the door?

Yes. I mean, look, we're not -- by no means are we where we'd like to be, right? I think if you look at lead times, lead times have extended, right? The lead times have extended from suppliers to us, and we've extended lead times to our customers, right? So it's not, by any means, perfect. The team has been doing a good job. I think we did -- we came into COVID in, I would say, our kind of lightest inventory position in a long time. That kind of got us to really focus on the inventory levels and the purchase commitment levels that we had. So we did make some investments, maybe a little bit earlier in terms of supply chain, placing orders, et cetera, because of that. And that's definitely helped us. But we are still in the same situation as other folks around having extended lead times and having to extend lead times to customers and facing probably the most extended lead times we've seen on the supply side. So I think maybe we got a little bit off to a better start, but we're fighting the same battles that everybody is fighting as we go through this.

And then I got a question that said, in late 2020, in the first half of 2021, consumers were spending left and right on web cameras, Zoom, home office setups, the consumer was spending a lot. Now that we're starting -- coming back to the office, there's the potential for the enterprises to really pick up spending. Is that true? Are you seeing that? Or did enterprises -- looking at your sales results, enterprises continue to spend quite well on procuring Arista products? How should we think about -- is there a handoff to enterprise? Or have you just been seeing very strong growth even during COVID with the enterprises?

Yes. I mean I think we've seen healthy growth with the enterprise kind of right through this, except maybe for those first couple of quarters where everything was very uncertain. And I think that's partly because we are a share gainers. I mean we are in a position where we're targeting opportunities and winning new logos. That's really the focus for us more than it is necessarily the macro. So even in the data center part of enterprise and even more so in the campus, we are -- what's more important for us is a pipeline of credible opportunities that we can go execute against and that we're closing against those opportunities, and we've been doing a good job of that. We're probably less exposed maybe to some of the macro trends. Although you are seeing now as people go back into the buildings and they think about going back into the buildings, how do you manage kind of a hybrid-type work environment? What does that mean for IT infrastructure? And we're seeing some good conversations around that. What kind of flexibility do you need? What kind of bandwidth do you need to be able to operate in an environment where half of your people are at home and half your people are actually in the offices. And that's driving some more video and some more bandwidth demands, et cetera. So -- but I think for us, it's still more about a pipeline of solid opportunities and execution against those opportunities.

I know you work with Jayshree a lot as well as your Investor Relations team. Can you maybe comment on 2 or 3 items -- we've got such a big audience here -- that you want to use this opportunity to educate or clarify or answer any questions that you get asked a lot about. And then I'll wrap it up after that by asking you about what you think are the couple of things that investors should be buying Arista stock. But why don't we talk about the clarification items first?

Yes. I think, look, the Arista strategy, if you like, right from the beginning, has been very consistent, right? And I think that's very important. It was -- the company was formed around a new architecture to really support cloud networking and support a network that was resilient and robust and had enough -- had sufficient quality to really support a cloud-based kind of business models, right? And I think we always had the belief that over time, that cloud architecture will become relevant to service providers and then will become relevant to large enterprises, et cetera. And that took time. But as you look now at what's been happening and what's been happening in our business, that clearly is the case. And COVID may have helped that a little bit. But now, the very few large enterprises [ are large ] that don't have a dependency now on the network and on online activities, whether it's manufacturing, commercial, retail, take your pick, every business is now -- has an online dependency, and those cloud-based networking features have become more and more important. So I think for us, it's been very gratifying to see kind of the relevance of those differentiating factors become more relevant across the different parts of the market, and we've been investing to support that, and we'll continue to do that. And I think that's -- the cloud heritage is hugely important and we'll remain laser-focused on that, but also all of the lessons that we've learned from that are now becoming more relevant across the enterprise as the company continues to evolve.

And then a couple of items that you want to convince investors while they should be buying Arista stock that you look forward to as CFO, of putting up numbers or growth, or putting the meat behind the statements?

Yes. I mean I think, look, the success of Arista has been around a focus on product and generating what's a really great product that is differentiated and that customers can appreciate the quality and the resiliency of that. And that is a core principle. As we expand, as we add capabilities, there's never a lack of focus on ensuring that, that quality and the quality of that software continues to be maintained. And history has shown that, that's fundamentally important for customers. And even more so now where everybody is facing a world where they need to be kind of up 24/7 all of the time. And that's really what's driving the company's success. Right? It all goes back at the end of the day to the product. We've been building sales capabilities, et cetera. But really, that rock-solid software capability and software team is what's driven the company's success and will continue to drive the company's success. But that is still super relevant across different parts of the and even more so as time goes on.

Well, for those on the line, I do want to be respectful of Ita and her time because she really has an oversubscribed list of investor meetings, and we appreciate your time and effort. And sincerely, we hope, in the future, again, Ita, it will be yourself and me sitting on stage in front of a live physical audience. That would be good again. But until then, thank you so much for spending time with us, Ita, and we greatly appreciate it.

Thanks for having us. And yes, we definitely look forward to doing this in person soon.

Thank you.

Thank you.