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

Good afternoon, everyone. Welcome to Day 2 of Citi Global Technology Conference. My name is Atif Malik. I cover U.S. semiconductor, semiconductor equipment and communication equipment stocks here at Citi. It's my pleasure to welcome Ita Brennan, CFO of Arista Networks. So we also have Liz Stine, Director of IR in the audience. Welcome Ita.

Thank you so much. Thanks for having us.

I'm going to start with my questions first, and then I'll take a break and ask you guys if you have any questions. And if you have a question, please raise your hand, and we'll get the mic to you.

Ita, we were talking about the A word before the fireside chat. So I'm just going to get straight to that. What is the AI opportunity for Arista and how meaningful of a revenue contributor, is it today versus 2 to 3 years ago from now?

Yes. I think, look, there's been some industry analysts who have tried to size this market in terms of just the Ethernet switching piece. You've had kind of a $2 billion to $3 billion number being tossed around. But in reality, I don't think anybody has a proper sizing of the market yet, and that's just going to take some time. Certainly, in terms of the products that we sell and the products that we will sell, it's not going to be completely obvious, what use cases they're being deployed in. So again, we'll have to track that somewhat off system to get some kind of sizing on that market. But today, we're selling those products into various different use cases. I think what's interesting for us around AI is, obviously, we've been selling products into kind of the front end of AI networks probably for some time without even knowing that, right? We were transporting data from some of their back-end processes out across their networks. I think the more exciting thing now obviously is talking about kind of what does the back-end of these networks look like and what kind of opportunity can that drive? That's right now, we're in the throes of kind of that's driving lots of technology development, urgency around some technologies that were in the pipe anyway around moving 800-gig speed, some software features, et cetera. So I think more than having a clear discrete view of exactly what it's going to mean in the near term, it's more exciting about the fact that it's driving urgency around the technology, and it's allowing us to continue to develop new features and work with customers to develop new features and expand that relevance over time. So I think today, it's -- we probably have some AI dollars on the front end of the processes. I think we're in the very beginnings of trials, pilots, et cetera, around some of the back-end processing, and that's going to continue as we go through kind of next year and beyond, but it makes -- it's a very interesting time for the engineering teams, the software teams, et cetera, to be able to engage with customers around some of these problems and some of these fine solutions.

Great. Let's talk at the cloud CapEx. What is Arista's visibility with regards to Cloud Titans investments in classic cloud computing?

Yes. It's been interesting, right? We're just coming off of this most bizarre supply period that we had, right? We're still working hard to fulfill some deployment schedules that we agreed with those customers some time back, right? So we're continuing to execute against that. And we're improving lead times. Hopefully, by the end of the year, we'll be back to like a 6-month plus or minus lead time. So we're kind of getting in a range now where we're starting to see customers start to figure out kind of what is the next level of demand would those new lead times look like. We still have work to do around that. But you can see that they're continuing to invest both in the kind of traditional classic networks and also supporting some of that front-to-end AI and then obviously lots of discussion around kind of what other use cases can there be around AI into the future. So I think we'll end up back. It used to be a turns business in a quarter in the old days, pre-supply chain. Hopefully, we'll end up something a little bit longer than that, especially given some of the lead times on some of the key components. So somewhere around 6 months is probably where we'll end up.

Great. Ita, when I look at the workloads in the cloud, the majority of them are still like analytical based and it's not AI everywhere. And so at some point, the demand has to kind of come back to the general purpose servers. And for you guys, the 400G side, are you seeing any kind of green shoots that the focus is shifting away from 800G to 400G or is it still quite early?

You mean from 400G to 800G. Yes. I think it's a little bit early, right? Because you're just not -- you're not quite there yet. It takes time, and we have silicon now for those products, but it still going to take some time to actually ramp the systems themselves, the software get them qualified, et cetera. So I think 400-gig is going to drive kind of revenues for -- certainly through the next period of time here, right, which is normal, right? I mean, normally, you see silicon, it will take somewhere like a year plus to get to a system fully qualified kind of revenue shipment from there. So it's not unusual. I think 400-gig is going to be the speed of choice here for a while. And then even when we go to 800-gig, you'll see a whole refresh of kind of 400-gig, 100-gig platforms leveraging silicon as well, right?

Okay. And then on the enterprise side, you guys saw strength in the last reported quarter, you just talked about campus switching, routing, how meaningful are Arista's campus switching and routing portfolios from a revenue and margin perspective?

So routing is hard to break out. I mean a lot of our routing work was initially done for the cloud and for the hyperscale customers, and we essentially rebuilt the routing software stack for those customers. And we've definitely earned a more prominent position in some of their WAN networks as a result, right? So we have products that are shipping into those customers, some being used inside the data center, some being used for routing because that's the beauty of the overall solution, right? It's the same box. On the campus side, we've talked about -- we were shooting for a $400 million number last year. We were shy of that a little bit just because of supply, but the demand is there. We have a target of $750 million for 2025, and we're on track for that number. So it's becoming a more significant piece of the business. And not only is it driving dollars kind of for the campus piece of the business, but it's also opening up sometimes some opportunities to sell into the data center. Again, it's another avenue of entering an account, entering a large enterprise account is to actually engage on the campus side and then win that, and then we can kind of work our way back to the data center, in some cases, obviously, it works the other way as well, just depending on the customer.

And Ita, when I talk to Jayshree, she sounds very excited about incremental share gains on the enterprise side from the incumbent and we saw through earnings results like Juniper, you, Cisco, you all guys had good kind of upside on the enterprise side. So help us understand how much of the strength you're seeing are share gains versus kind of the organic market?

Yes. I think particularly in campus, like the overall market itself, I think, over a period of time, hasn't been growing that aggressive. You saw a little bit of growth recently, but it's still not an aggressive grower. So it's really more about kind of where we're taking share in that market, right? And we're targeting customers, high-tech customers who are looking for the benefits that we can bring with EOS, with CloudVision all the way through kind of there, in some cases, data center network through to the edge or in their campus networks. So I think a lot of what we're seeing is really share gains. I mean we're still very small in -- it's a very large market. And there's a real opportunity to be a new supplier to that large enterprise piece of that campus market, and that's kind of where our focus is. So I think the excitement I think that we see is, we are seeing good, we're being pulled into opportunities by those customers by those large enterprise customers, and we're becoming more known kind of in that part of the market. And it's more diverse. It's across lots of mini, what we thought mini verticals inside that enterprise, but seeing customers in the manufacturing world or in the -- Jayshree is trying to give some color just to the types of customers that we're winning now. And it's way broader than what we used to do prior. And I think that's part of the excitement as well is that we're actually -- we actually now have like credible solutions and references for different verticals within kind of that campus footprint as well.

Great. And then putting it all together, Jayshree gave us a little bit of a teaser on the earnings call on the double-digit growth next year. And I don't want to front run your Investor Day in November. But how should we think about the bridge from cloud this year into next year as well as the enterprise demand, perhaps sustaining. Maybe you can walk us through some pointers.

Yes. I mean I'd still go back to the thesis we've been sharing for a while now, which is after 2 outsized growth cloud years, we do expect cloud to be muted next year. AI is helpful in terms of the long-term picture, but we're not sure that it changes that dynamic, right? So I think we put out some guidance at the last Analyst Day that had us growing single digits in that 2024 kind of when you back-solve the CAGR. Jayshree has had a desire and a goal that she's been driving the organization to say, could we at least get to 10%, right? And I think we're becoming more comfortable with that over time, hence, the teaser. I wouldn't get too far ahead of us beyond that because I think it does assume that cloud is muted and that we are relying on kind of the enterprise and consistent execution in enterprise, et cetera, that's certainly one way to get there. And we'll talk a little bit more at the Analyst Day about maybe some other drivers there that can kind of -- I like to have the multiple building blocks. We'll talk about that some more. But I think it is kind of a lower double-digit number, assuming that cloud is muted, and then we'll see where we go from there.

Great. Let's start with the margins, how does customer mix versus product mix rank in terms of driving margin expansion?

I mean customer mix is still by far the biggest driver. I mean we have some tidy up to still do on supply chain. We have a big focus internally in kind of putting supply chain back in the box just in terms of cleaning up purchase commitments, getting some of the inventory metrics back to normal. And then earning back kind of some of the cost increases, et cetera, that we bore because we expect customers to come and ask for that back on the front end as well over time. So that's kind of work that's in progress. That's been helping us kind of improve margins as we've gone through the year. And I think we can continue to do that through the end of the year and then it probably stabilizes from there. Then we'll be back to really the biggest driver being customer mix. And we're obviously, cloud with its heavy cloud, it will have a lower gross margin, but then still significant flow-through to the operating line. And obviously, when enterprise is stronger, we've got a higher gross margin, but then we will continue to kind of add sales and marketing investments as we go to support that business.

And are 400-gig switches higher margin than 100-gig?

I mean it mostly nets out, right? If you go back and plot kind of our gross margin over time, right? It tends to net out. And some of that's intentional. I mean, obviously, we're negotiating all the time based on the underlying cost structure. So as best as you can, you're always trying to match kind of some of the cost pressures that you're getting with some of the price reductions that you're having to give and we manage that across the products. So new products tend to have -- initially have a higher cost and then kind of work their way down, well, we try to manage those in tandem. So you haven't seen that much of a change in gross margin across the different product cycles.

Margins, you've had tailwinds this year from COVID disruption as things are starting to normalize in supply chain. Will that remain a tailwind through the end of this year and how far more headroom there is for margin expansion from supply chain normalization?

Yes. I think we've talked about gross margin kind of stabilizing at the end of the year with maybe there's probably hopefully another bit of improvement kind of through the end of the year. We've kind of been stepping kind of improving as we've gone through Q3. And then I think it probably stabilized. And then it will come back to more just being about customer mix and what consumer mix looks like.

All right. This is a question on investors' mind in terms of the CFO transition as you're going to be stepping away. Is Arista pursuing an internal or an external search? And what is the targeted timing of the transition?

Yes. I mean we obviously talked about it early, right, to give us and to give everybody else a chance to kind of absorb it and give us some time to look for the right person. So we're engaged in that now. I'm committed to being part of that process and helping with the transition. And so however long it takes for us to get to a good partner for the team. Going forward, that's what we'll do, right? But it's sometime next year, for sure, to just depend on when we kind of find the person that everybody is comfortable with.

Okay. And then on the OpEx side, how do you guys kind of allocate the R&D priorities across multiple areas in enterprise and 800G and AI?

Yes. I mean a lot of the core kind of software work is leveraged across all of it, right? And when you think about EOS and just moving as we go through the speeds and we add features like routing and other capabilities, that's shared kind of across -- that's part of the model. That's why the model works so well, right, is that those investments, they are initially driven by cloud, but then they're shared across kind of other cloud service provider and through the enterprise as well, right? There are certain things that we do that are for the enterprise business, right? And we've been working hard to become a little bit more disciplined about carving those out, and Jayshree has a big focus there in terms of making sure we're doing enough, that's CloudVision, some of the visibility tools, automation, some of the campus-only kind of features that we want to fill in, but that's still a relatively small part of the overall lift just in terms of where the resources are going. So there's good commonality across the different parts of the business for a lot of the R&D.

Okay. And it will be helpful to know where we are in the 400-gig upgrade cycle? Are we like 20% through 30% or?

Yes, it's been harder to kind of -- we used to think of it as like, well, 40-gig, then 40-gig goes away and you get 100, and then 100 goes away and you get, and then with this last set of products, what you've really seen is 100 is continuing to be deployed broadly, right? You've got 200-gig in certain cases for certain customers, then you have 400-gig. So I think even after we have an 800-gig offering and it's being deployed in certain cases, you're still going to have some customers who will be deploying 400-gig and 200-gig, right? So it's been those high speeds, they're becoming -- the silicon is changing underneath and you're getting a whole new set of more efficient products, but customers are still deploying different configurations depending on the use cases. So I think we're obviously well into the 400-gig deployment. But if you think about the business, say, last year this year, I mean we're still deploying a lot of 100-gig too kind of in that time frame, new 100-gig, more efficient, power-efficient, et cetera, with new 100-gig. So I think we'll see -- we're obviously getting a lot of dollars from 400-gig right now, and we'll continue to and probably continue to even after 800-gig shows up.

Okay. Ita, when we talk to Cisco, I mean they acknowledge that the guys -- I mean those guys have lost 400-gig to you guys. And on 800-gig, there it seems like they're putting a bigger focus. So how should we think about competitive dynamics going into 800-gig?

Yes. I mean, I think we've gone through multiple cycles now where it's 100-gig, 400-gig was supposed to be a cycle where there was a lot of noise around competitive products. We'd expect the same again at 800-gig. I'm not at all surprised if I was in their shoes, I'd be putting wood behind 800-gig as well. But again, it all comes back to -- we have to execute well. We need to -- if we deliver the right products, if we work with these teams in these customers, we can earn our fair share of that business. And we'll let the competition take care of ourselves. But we've been -- the team has been doing a really nice job of executing well against products with these customers. We saw it at 100-gig, we saw it at 400-gig. Again, there's a huge focus on 800-gig now inside the team. So I mean, I wouldn't bet against them continuing to drive that execution because it really is all about execution for these customers, right? Give them a product that's reliable, has a software stack that you can ramp straight away, that's what wins you that business, right? So we used to stay focused on that. And I mean I would expect them to compete hard for that. But I think the team is good at this. We just need to deliver.

We were just coming back from the NVIDIA fireside session and they had this chart where InfiniBand is growing like 4x and so obviously, they're seeing the success on InfiniBand in the first wave of 800-gig. And the big debate is like what will be kind of the mid- to long-term mix of this market. And when we talk to fabless companies like Marvell and [ Spire, ] it sounds like the Ethernet is starting to get adopted as well or being evaluated right now into next year. So would love to know your thoughts or if you're seeing any kind of green shoots for Ethernet adoption for 800G?

Yes. I think at the end of the day, what's going to matter is kind of what gives you the best AI-enabled network, large network. I mean that's what we're solving for, right, is being able to have these large multi-tenanted, large footprints with -- from a customer's perspective, with multivendor, multi-providers and lots of contributors to that architecture in that network. I mean that in our minds is what's going to win, a standards-based, right? And that is -- that's our Ethernet strength at the end of the day, right? If you look at the history of how Ethernet has evolved over time, right? It is a standards-based broadly deployed architecture. And we believe it can solve any problems that need to be addressed around AI. There's some work to do there, but we're continuing to do that, and it will continue to evolve, right? But customers are going to look for that environment, right? That sort of allows them to scale to the levels that they're going to want to scale this to, if AI is everything that we believe it's going to be, right? So I think we're betting on Ethernet because we've seen multiple different architectures kind of try to compete against Ethernet. But in that environment where you want to have this kind of large standards-based open architecture, Ethernet tends to win. Now again, we have work to do. We need to do it. But I think from a customer perspective, that's a solution that they're using today. It's deployed pervasively today. They have the expertise there. So we believe that that's where it's going to end up. It won't be 100%, but there will be -- those large-scale footprints will -- we think will end up deploying Ethernet. But again, there's work to do. We need to just execute and do it, but customers are definitely interested in making that work.

All right. And then the threat of white box makers in terms of competitive landscape, that question never kind of goes away. When we look at the Dell'Oro data, it seems like that share has kind of stabilized for white box makers. Can you just talk about what you see in the market for white box makers?

I mean, I don't know that there's been any fundamental shift in white box for a while now, really, right? I mean it's -- you have kind of the 2 large players that do their own, then you have kind of the dual co-development arrangements that have been in place, but it's been pretty balanced, right? And the more complexity that there is, the more change that there is, that doesn't tend towards, I think, more white box, right? If anything, it probably balances it out and maintains the status quo. So I don't know that we've seen any shift kind of towards white box for a while. But that question never goes away, right? We've been answering that since I joined Arista and that was one of the first questions, big concerns that everybody had back then. So yes, I don't think it's changing that much.

And what has to change for you to change your share position at kind of the large Cloud Titan that I think investors expect at some point you'll have a shot at. Is it something on their side? Or is something on your side that you have to kind of technology wise get to meet their requirements?

I mean I think on the technology side, there's good alignment from a technology perspective, and Anshul's commented on that before. It really is -- it's a huge decision for an organization to make. So it's really in their hands to decide kind of what makes sense for them. I mean we'll continue to collaborate, share, technology, et cetera, and it really is in their hands. But again, from my perspective, I've said this many times, it's not something that should be in the near term because we can't control it, right? So again, we'll continue to build those relationships and share technology, and we'll see where we end up.

Great. Let me pause here and see if there any questions in the audience?

I was hoping we could go back and talk about margins a little bit. In the most recent 10-Q filing, there was a note that one of the contributors to the decline in margin was provisions for excess inventory obsolescence. So just hoping you could talk about that a little bit.

Yes. I mean, obviously, our inventory has been growing and particularly kind of on the raw material side of things, the inventory levels have been growing. We always have a certain level of reserves that we carry to cover that inventory. As that inventory has been growing, we've been increasing those as well. I think it beholds us to make sure that we have kind of a consistent level of coverage on those inventory balances. When we came into this whole supply situation. We always knew it wasn't completely risk-free, right? But we thought it was a manageable risk. I think we still feel that way, right? We're working through the purchase commitments and inventory and making good progress there. But at the same time, as that inventory balance grows, we want to kind of -- we want to continue to maintain some coverage on that not because something that's going to happen today, but obviously, it's the tail of that inventory that you want to make sure you've got some adequate coverage for us. So we are keeping an eye on that. But I think by the end of the day, as relative to the inventory side, it won't be that different to what we normally do. It's just obviously, as the inventory is growing, you're seeing those increases go through the COGS numbers.

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I mean the finished goods is still -- I mean, if you look at it, our days of inventory on the finished goods side, it's still not nearly back to where it was -- free. That's -- I mean it's because most of the inventory growth has been in the raw materials, that's kind of where we're addressing that, too, right? Just because we're really kind of just working on the basis of the inventory balances are growing, right? That we should kind of cover that off.

Maybe if you can maybe double click on the kind of challenges, Ethernet has to solve now to gain more share on the InfiniBand? And maybe kind of from the get-go, what InfiniBand has that Ethernet didn't? What are the different obstacles that Ethernet has already surpassed to kind of gain more share on the InfiniBand, just double picking on the challenges in Ethernet already surpassed and what's remaining?

Okay, I'm going to try, but remember, I'm the CFO, so it may not be very satisfying. Yes, I think, look, historically, InfiniBand probably had higher speeds, right? Ethernet was kind of -- was needed to catch up on speeds. I think we're pretty much catching up on speeds now, right? And then the other piece was just kind of the management of the traffic flows, right? This whole rocky discussion, right? Where Ethernet now also has basically learning from InfiniBand over time. Now has some of that -- has the ability to kind of manage those flows as well in Ethernet. So a lot of those things have been -- a good number of those things have been solved. I think Jayshree put it well on the conference call, which is like neither Ethernet nor InfiniBand today is perfect for AI because that's a whole new kind of use case and challenge. So I think both technologies will need to evolve and will want to evolve, right? And a lot of it is around just managing traffic, making sure that you get to that lossless or Anshul likes to say, almost lossless, but really lossless delivery because that's what you need for AI, right? So there's some more software management, management of those flows that you can do to make sure, right, that you solve for that. So that's an area for sure that we'll continue to work on between buffers and then making sure that you have that predictability and that you deliver every package gets delivered, right, is a focus for Ethernet. On the InfiniBand side, I know there are other things that need to be solved there, too, but a lot of it is just to do with the fact that it doesn't scale to these multi-tenant and that it's not open. And then it's not kind of -- you don't have that same standards-based supply base that you do on the Ethernet side.

Ita, are there other adjacent markets that Arista is considering entering? And also if you can talk about the software opportunity. Because when I look at the 3 networkers, Juniper, Cisco, you guys, you all talk about software and other unique drivers to your software attach rates.

Yes. So I think we're a little different in that. We haven't tried to take the core operating system, EOS and bundle that separately, right? I mean for our kind of that larger enterprise customer base, that's not something that they're interested in doing. It doesn't resonate well with them. So it beholds us to get paid in terms of the actual pricing on the port and the hardware, but we don't have a separate software stream per se for that, right? But obviously, we continue to do a ton of work there, and that's what earns us kind of the market share that we have, right? So then the other piece of the business is more around the subscription stand-alone products where customers where you do have a choice and they get to buy those software products if they think they add value, right? That's CloudVision, that's some of the visibility tools. It's some of the AVA security tools. So those we sell separately, we sell it as a software subscription. I mean in terms of do we -- what else do we do? I think we kind of balance all the time between if we only did 2 things well, if we executed well in cloud and grew with that business. And if we continue to execute in the enterprise and campus and take our fair share of that market, that drives a very healthy business in and of itself, right? So you need to say, there's an element of focus that you should have in executing against that. And I think what you're seeing us do is kind of fill in where we have gaps in that -- in the campus offering, in particular, and where we've been partnering or needed to partner and where it makes more sense for us to actually do something ourselves, whether that's the WAN product that we announced, whether it's kind of the AGNI, the NAC product that we announced, right? So stuff like that, where it truly does make sense from a customer perspective for us to kind of solution that as opposed to introducing something else into the middle of that. That doesn't mean, we won't partner that there won't be things we'll partner with, there always will be, right? But there are certain areas where it's somewhat disruptive to the overall solution where we drop things in, and that's what you've been seeing us do over the last while, and we'll continue to do that.

All right. Great. We can wrap it up here if there are no questions. We still have a few minutes if you want to talk to Ita, but, Ita, good luck in future and thank you for coming to Citi Conference.

Thank you for having us. Thank you.