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

Well, thank you very much, folks, for joining us. My name is Simon Leopold, Raymond James' data infrastructure analyst, and I'm pleased to welcome for our fireside. We have with us from Arista. We have Ita Brennan, CFO, retiring in a few months. So we're grateful that you're spending your remaining time with us; and Liz Stine, who's running the IR department.

So format for this is fireside chat. I've got an outline of questions that I'll go through, but love to get questions from the audience. If you wave at me, I'll try to call on you, and we'll repeat questions or we'll check in towards the end to see if you've got any questions. Do you need to read any disclaimer, anything like that? Okay. Awesome. I hate when I'm responsible for that. It's too much for me. You think I'd have it memorized by now. So I want to sort of reflect back on the recent Analyst Day because you provided an outlook for '24 longer term. And so I like the timing of our meeting because December, everybody is thinking about 2024. So you forecast this 10% to 12% outlook. Help us get a better understanding of what informed you in terms of whether it's thinking about the verticals, the trends, the cycles, back up, what led to a 10% to 12% growth outlook for the next year.

We're going to try that again. Yes, we're coming off of 2 years of fairly aggressive growth and pretty elevated spending from cloud. So I think we've been saying for some time that we thought kind of 2024 would be a more moderated cloud year. And you're kind of coming out of the 400 gig cycle a little bit and then you're starting to talk about and think about 800 gig. So it's been kind of our belief for some time that if we see cyclicality, this is kind of when we would see it. So that's definitely underpinning kind of the growth rate as we think about 2024. But obviously, the enterprise piece of the business, that has continued to do well. It continues to grow nicely, a little bit of good in '23 with some supply chain staff. But even when you normalize for that, it was kind of slower in '22, a little bit faster in '23. But when you normalize for that, it's still been growing very nicely, very consistently. So that's also an input. So taking kind of that and thinking about that cyclicality, thinking about deployments that we know about and what we can see, discussions with customers, et cetera, and all of that informs good at that 10% to 12%. And again, we like to have a couple of different ways to get there because it's early to be sitting here talking about the whole of 2024. So having a couple of different models that can get you there is important. And then we'll see where we go from there.

So I appreciate that you're not guiding by vertical, but maybe it would be helpful to sort of get some sensitivity around the 3 verticals you talked about, cloud titans, enterprise, and then service provider/other, which do you sort of feel are above and below, which sort of have the greatest variability, which do you have the greatest confidence in? .

Yes. Look, I think it's probably too early, honestly, to start to kind of pull it apart in that way. I mean, we do again, have multiple different models that kind of assume different things about those verticals, that's part of kind of how you get comfortable with the view. But I think it's too early for us to start saying here's a single path that gets you there. I mean we talked a little bit about the cloud just because it's a driver of kind of the change in the growth rate. But other than that, I think we're just going to go kind of quarter-by-quarter, and maybe midyear, we typically start to talk about a little bit more about kind of the customer and the vertical breakout.

And one of the common themes we've been talking about is the post-pandemic normalization. So companies sort of entered the supply chain constraints in different point and built up different level of backlog. And so I've sort of looked at having backlogs and insurance policy in the near term, but then it creates a tougher comparison later on. Where is Arista in terms of this cycle of adjusting to normalized backlog and normalized trends?

Yes. So we don't talk about backlog and bookings, and we very much decided as we came into this supply chain cycle that it was unhelpful really to talk about or to try to talk about bookings in a time frame where your planning horizon was going from a quarter to 12, 18 months, right? It's very hard to say that our bookings number has any real significance in that environment, right? So what we tried to do is to take the bookings and kind of turn it on side and figure out exactly when these deployments belonged almost, right? So where and when should they be deployed. . And we're continuing to do some of that still, right, where we're making sure we prioritize shipments, obviously, early on, now we're making sure that we're kind of putting shipping to customers when they need it, when it needs to be deployed, et cetera. And I think that helps manage some of that adjustment that you're talking about, but there's still no easy way to go 18 months of lead time to wherever we'll end up 6 plus or minus, right? You do lose some visibility as you make that transition. We've been talking about that the reduced visibility. But I think if you focus on the deployments, that's kind of the right that gives you the best measure you can have of the business when you're trying to make that transition.

And I do feel like talking as if there's a true normal is a little bit nonsensical. That is my preface. Are we closer to normal? Or are we still sort of working through that?

I mean, again, in terms of the business and the deployments, we've been that's the underlying business, right? So what you're seeing in revenue for us is really the underlying business and when customers really needed to have that deployed, right? So I think from a business perspective, we looked through the bookings to kind of when do customers actually want to deploy stuff. In terms of lead times, are we back to normal? I think as you talked about kind of improving 50% better than where it was coming into the year. I think by the end of the year, we'll be more or less back to kind of where we want to be from a lead time perspective.

Great. And I want to explore specifically your thoughts on the enterprise vertical. And really, the context of this question is broader around kind of the macro economy and how much that affects you and that we're here debating our interest rates going down. Is the economy healthy? Did we dodge recession? Did we not dodge the recession, all these debates and I want to get a sense of what's sort of your take on it. You have to have a view and then how does it affect your thinking for forecasting in the business? .

I mean it seems like we've been having this conversation now for years. I mean, really since we came out of COVID, it's been a question of kind of what's going to happen in terms of recession, et cetera. I mean again, I don't know that we're seeing that have a huge impact on the business. And part of it is we're share gainers in that space. We're targeting accounts, new win accounts, et cetera. So we tend to be qualifying accounts on the basis that they have an intent to spend. They have [indiscernible] they have money to spend. That's the first thing you should qualify and count on when you engage with an account. So there's some protection in that for sure because you're not just exposed to the whole market. But having said that, if there were to be a serious macro impact, then I think it would impact us as well, right? I mean there's no abating that if you had a serious kind of distortion.

And sort of in light of that, the other angle is how are you thinking about hiring plans? And really, as I'm sort of thinking about my group, I'm seeing many of my companies having to do layoffs because they've over hired and things are slowing, where you're in a very different situation. Your revenue grew far faster than you could hire. So with the way you see the business evolving, what are you thinking about in terms of hiring objectives and sort of budgeting for that? .

Yes. I mean, obviously, when cloud burst and the way that it did in '22, '23, we don't hire to that burst, right, because it doesn't really make sense. I mean we have a very kind of methodical continuing hiring of software head count as we can find those, and that's become a little bit easier of late. And then on the sales side, it's really focused on the enterprise piece of the business largely, right? So we want to protect that regardless of what's happening with cloud to some degree, right? So again, that's more of a continuing hiring against that enterprise as long as we see return on those hires, I don't see productivity on those hires. On the enterprise side of the house, we'll keep doing that, right? So that's why operating margins sometimes will peak when you've got that accelerated growth, but then we might call back a little bit of that as we continue to invest in sales and marketing, for example, for the enterprise.

Right. And I guess maybe a related question is, you seem to be under-penetrated internationally. How are you thinking about investment to grow your international presence?

Yes, we have been hiring probably a larger portion of the head count that we've done has been going into some of those international markets. And again, we'll continue to do that. It's been more developed markets, more of the kind of developed parts of the world as our primary kind of target. So we'll continue to build out that enterprise footprint and add to that. I think we've been trying to target like a 30% increase in head count every year, if we could do that, we think that's something of a sweet spot where you can do it and maintain productivity. So that's the plan. I think we never really got ahead of ourselves in terms of hiring, like we've always been very cautious around making sure that when we're hiring, we're being thoughtful about that. And thankfully, we haven't had to really have significant layoff.

So I'm going to pivot to the favorite topic, AI, because what [indiscernible] AI. So you established this target of $750 million of AI-related sales by '25. First off, help us understand what's included in that number? What's the composition assumptions behind it?

Yes. I mean we're trying to isolate kind of the back-end AI revenues. So things that are connecting directly -- directly connecting GPUs on the back end. Ethernet, obviously, because that's where we play. It's going to be -- it's not going to be perfect in terms of how you track that, but hopefully, with the help of customers, et cetera, we can do that for some period of time. I mean I still think after, I don't know, if it's a year, 18 months, 2 years, you won't care anymore, what's an AI dollar versus a non-AI dollar. But I think for this transition period where there is these technology discussions and choices, it's helpful to try to give some indication of how we're doing there. So we're going to hopefully work with customers to identify that back-end business and that's what would be included in that number.

And just to be clear, the opportunity that AI presents is not just about building AI clusters, but what you're referring to as the back end, but there's also this front-end opportunity. That's not part of $750 million....

That's not part of $750 million.

And I think what you've said on the last call, maybe you was at the analyst meetings, hey, we're not sizing that because we don't know how to create a dividing line.

Yes. Yes, it's the same product, right?

So is there a way to sort of think about, hey, here's the market forecast, if we subtract what we think is AI, what's left? Just what's your TAM, maybe is the way to think about it? So AI plus non-AI?

Yes. I mean we talked about the TAM stuff at the Analyst Day, and you can see that the -- if you look at the -- what's interesting is to look at the TAM, say, from the last Analyst Day to this Analyst Day, right? We kind of increased the TAM by about $10 billion. About $5 billion of that is really AI and the AI opportunity in 2027, right? So that's incremental from an industry analyst perspective in terms of how they're thinking about. That's total Ethernet AI, right? Now again, that's not perfect today for sure because, in some ways, we don't know what that split is. So it's going to be hard for everybody else to track it, but it's at least starting to do a sizing on kind of what that AI Ethernet full opportunity can be.

So one of the questions we're often getting is that InfiniBand is the choice for the back end today. And I think everybody in the Ethernet camp is singing the same theme of in a few years, it's going to pivot to Ethernet. I mean Ethernet buy a sky as well. So I like to hear that as do my peers. But I think we're all struggling because the vendor of InfiniBand and the vendor of the GPUs really has a lock on that. They don't have a huge incentive to change. Now they've said, look, we'll do Ethernet too, but what sort of inform you from the marketplace, from the operators that we're really going to see this transition by 2025.

Do you want to take a shot at that from the technology perspective?

I think the benefits of Ethernet are really seen at scale, right? And as these environments get larger and larger and you've seen some of the cloud guys put out, some of these white papers now that are actually talking about their Ethernet environments and benchmarking them against from a performance standpoint. And then if you listen to them speaking, the scale just keeps getting kind of larger and larger. InfiniBand has some hard address limitations that limit the size of the cluster side. And when you think about Ethernet today, Ethernet is everywhere, right? And it can scale, and they're already running these Ethernet. Large Ethernet cloud environments and have the tooling and have the expertise in order to do so. I was joking with a couple of the investors we were talking to today, I was like, in Google how to troubleshoot an InfiniBand network and see kind of what comes up. But I think one of the other benefits, obviously, from an Ethernet standpoint is it's open standards, right? And that's very important. It's also multi-tenancy, right? You think about carving up these large GPU clusters and wanting to share it amongst different customers, you kind of need a multi-tenant aspect. So I think that we see as these things start to scale, that's where we see kind of that tipping point favoring Ethernet.

And maybe to follow up, is sort of what's Arista's differentiation because there's this sort of quandary of, well, Ethernet is a standard. So that means we've got several vendors that support it. So how does a vendor like Arista do better with Ethernet than the other people also doing Ethernet?

Yes. I mean Ethernet is a standard today, too, right? So it's all about, yes, there guess is a standard, but then there's also how performance and some products are better than others, right? I mean for the same reason as we win at, say, 400 gig, if you think back to the 400-gig cycle we had all of these discussions about how folks are going to come and take share and take some of our position with some of these customers. But in reality, the product was capable, was delivered on time, and executed well. Those things are not for nothing, right? So everybody asks like what if there's more Ethernet competitors; a, it's not easy; and b, we're used to competing for this business, right? .

I would argue incumbency accounts. So if you're at an account with Ethernet, you're more likely to stay at that account with Ethernet.

Yes, but there's no denying that every one of these product cycles, you have to bring your game, you have to bring your contribution from a road map perspective, from a technology perspective, and then you have to deliver really good products that scale, right? And there's risk in that for us every time, but we're hugely focused on that. If you lose sight of that, then that's your exposure, right?

Last year's Analyst Meeting, I think it was kind of an introduction or at least an introduction to the analyst group around this concept of transit WAN, which was like I think Arista kind of spreading its wings getting outside the data center. Can we get an update of where those opportunities stand and how that sort of fits into the forecast? .

Yes. I mean we do quite a bit of routing revenue at this point, data center interconnect. We've reworked the software stack, if you like the routing software stack for cloud. So quite a bit of routing revenue with the cloud customers as well. And then as we started to think about the enterprise space and the places where we had a gap in terms of the end-to-end solution that customers wanted and where customers were asking us to bring an EOS solution to bear. And that was one of those, right? . So we're early. It's early days in terms of that deployment, but it's very important to customers to be able to see product offering that will fill that gap. I mean this Analyst Day, we talked about the NAC products, that's the same idea where are you introducing something that you really don't need to introduce. If you can do it yourself. It's core to the network. We think we can drive a solution there. But it is early. I mean I think when we had talked about it last year, it was a concept, right? And so we're kind of close to a full product now, but it's going to take some time to start to see revenue from that.

So I want to pivot to the campus part of the business. So you've reiterated your target, $750 million by 2025, which is easy to confuse with the AI target because it's the same. You should just pick 2 different numbers that we don't get confused, but we won't notice. But I want to reflect back a little bit on the strategy because I think in the early days, the strategy was you were going to be more software-oriented and not get into sort of all these access points. And it looks as if you've sort of pivoted the strategy over time, you've kept the goals the same. Maybe before we sort of think about the outlook, I want to reflect what lessons did you learn in entering this business that's different than sort of your core data center business?

Yes. I don't know if there was really a change in a change in strategy or a change in fulfillment model, right? I think it was always our intention to sell the switches and sell the access points and then maybe what's different is for like for an access point, really all the value, if you like, is in the management software, the management plane, which we've run through CloudVision, right? And that's still the case. For the campus piece, it was very key obviously was EOS all the way through. And again, cloud business was managing. If you had a data center, you could manage a single image from your routing through your data center through your campus through to the WiFi. So I think all of that has pretty much stayed the same. I think if I think about surprises that we've had, I think we were surprised how much of the business is coming to us as campus first or campus only, right? We had assumed that for the early stages for sure, we would be really using in our data center heritage and those customers to move into their campus solutions and that it would be harder to win campus only solutions. But we have seen a fairly balanced mix between new customers to us. So I think that's been good. That large enterprise part of that campus market is -- there's still a very dominant competitor there. So there are customers that are looking for an alternative to that either because of the technology, because of their experience, because of the fulfillment model that they're driving, lots of different reasons, right? But there's definitely not a lot of competitors that play in that space. And so there is a real opportunity there to compete for campus only. And it's nice to have a -- sometimes with the data center, you have to wait a long time for a data center opportunity, but now you can insert with a campus opportunity and something else as well in one of those targeted accounts.

And can you talk a little bit about the go-to-market. You did mention targeting large enterprises. So I assume you win one deal, they're relatively big deals rather than winning 1,000 sort of small businesses. So probably a little bit easier in the channel, but what's sort of your split between direct and where are you in terms of developing channel partners? .

So I mean we're still -- our primary kind of near-term goal is to target that large enterprise customer, that's a direct sale, and that's where we keep adding salespeople. We can continue to get more coverage and add accounts there. If they don't necessarily pop in the same way. You do a data center. It tends to be a big spend with a campus, you could do an initial campus and then another and another. So a little different from a spend perspective. . If you think about the market, it's about half of that, including WiFi $40 billion market, about half of it is in that, maybe less than half is in that large enterprise business part of the market, that's addressable that way. And then as you start to move down mid-market, that's where the channel becomes much more important. So I mean we are adding channel partners. I think there's a relationship between how successful are you in the enterprise. As it drives the brand, even though we don't necessarily have the channel to sell for some of those opportunities, they would be fulfilling some of those opportunities, they could be in services for some of those opportunities. So the more that you are present in the enterprise, I think the more that channel becomes easier. But it is going to take just no easy way to somebody is asking us today, can't you just turbo? But it is going to take patience because there's already some incumbents with large presence in the channel. So we have to kind of find those channel partners as we go. But we've got partners now who probably would never have engaged with us 3 years ago, 4 years ago.

And I want to ask sort of a competitive landscape question, but I want to make it a little bit harder in that, the easy answer is always like we're going to take share from Cisco. We get that. But when I think about the narratives from the bigger competitors like an HP Enterprise with Aruba Central, and Juniper with Mist, they seem to have very similar strategies to Arista's where it's large enterprise. It's taking advantage of Cisco's weaknesses and complexity. So how do you compete against those kind of players? .

Yes. I mean it's interesting, again, when you look at that like large enterprise piece of the market, there still aren't a lot -- there's not a lot of share that's going anywhere other than that key vendor in that large piece, right? There's still a lot of those players are still in that mid to maybe bottom of that large enterprise market, right? So our target is very much the big bet, large enterprise customers to start with. But we do see the other guys sometimes, but it's largely against that one incumbent still, right? I mean that's where we're competing. Those are the opportunities that make the most sense for us right now. I don't know, product-wise, if you want to add anything.

I think value prop wise, our campus story isn't really much different than the data center story, right? It is all about the quality of EOS, the operational efficiencies that you get with CloudVision, the visibility. And as the campus becomes more and more complex, and you think about campus isn't just an office building any longer. It is a hospital building, it is a hotel. There's so many more definitions of campus in those networks that are becoming more complex. Customers need a quality operating system. They need the tools in order to run these larger footprints and we give it to them with the EOS and CloudVision.

So do you have any certain long-term goals for this business? Because my recollection is when you first announced it, there was sort of this aspiration of at some point being 10% of market undetermined time, but how do you sort of think about making it meaningful? Because it's $750 million, you're clearly not done.

No, we would certainly hope not, not to me. Yes, I'm not going to try, especially now that I'm about to retire to bring in on Jayshree's targets for campus beyond that. I think we'll execute well against the $750 million, and then we'll go from there.

Topic you and I have talked about before that I think is interesting in being different is your thoughts on a software strategy. In that so many companies in my sector have sort of pivoted towards software because you want to have a software model, you want to have recurring revenue because that gives you a higher multiple. You don't need a higher multiple. So you've had maybe a different take, but maybe help people understand how you think of the software business within Arista?

Yes. We've thought about this a lot, right? Because when you see everybody around you're doing something, you have to ask yourself, should you and why aren't you. I mean, Arista is a software company. You know that because 90% of the R&D resources we have are software people, right? I mean it's a software company. That's what drives the capabilities of the product that customers are deploying. It happens to get sold with the switch, right? We thought for a while, should we, in some way, take the core operating system, EOS and say, okay, we're going to sell this separately. But then what are you selling as a box, right? You're selling a box that doesn't work or you're going to sell a box that the customer can use for a year and then somehow it's going to stop working. It was just a lot of friction with customers. Large customers generally want to capitalize their hardware and software together. They want to have a perpetual license, they want to buy it. And to us, honestly, the economics of it make are not that different. These customers are smart enough to realize that if you do a subscription, then it costs 50% more, it costs 50% more, right? So there was really no substantive benefit from a business perspective. And if anything, it was just causing churn and friction for customers, and so we didn't see that there was a need to do that, right? But for offerings that are stand-alone, value-add, like CloudVision, like the visibility tools, the security products, those we sell as a subscription license, customers get to choose whether they buy it or not, it doesn't hinder the switch from working. It's there decision if they see value and they can buy them. So those are software subscription licenses and we're selling those. And you see those show up a little bit in services and in the product revenue line.

How material is that within the business?

I think the last time we talked about it, it was kind of single digits. It has kept pace roughly with the business, which is not nothing given how we've been growing, right? But obviously, it gets dwarfed again by the product just because the product has been growing so fast. But so it's a contributor to gross margin. These are very important offerings from a customer decision perspective from the strategic discussion with the customer, et cetera. But we still believe that taking EOS and trying to somehow artificially separate that is a bad idea. And really recurring revenue means I went at 40. I went at 100, I went at 400. I went that's recurring revenue in our regimen.

Sure. Let me check with the audience if anybody's got questions. If not, I've got plenty. Sure, we'll repeat it.

[indiscernible].

Yes. I mean, again, we don't talk about the backlog, honestly. So I'm kind of not going to do that here when you think about managing deployments, and we've talked about a little bit in the last filings that we're still deploying things from those prior arrangements, and we'll probably continue to do that into next year. That's much I think as we've said about backlog. Visibility is obviously, we've talked about visibility shortening, visibility has shortened. So I think by the end of the year, you're somewhere. Is it normal? If you think back to pre-COVID, we were turning business in a corner, right? So we will end up having some flexibility to turn business in the quarter again here before too long. But we'll definitely have some extension of kind of the lead times overall and the visibility overall from that? .

So I always like to close with the same question, which is, what do you think is the least appreciated aspect of the Arista story?

Yes. I mean, I think it comes back to just how powerful these 2 businesses inside one can be, right? And we have to continue to execute on it. But this cloud business that is -- these are amazing customers who are growing investment and growing revenues on a huge base, right? And they continue to do that and they can continue to do that. That's one piece of the business, put it cyclical and maybe it has lower gross margins, but pretty healthy operating margin still. And then you have the campus piece of the business, which if you do that right, you can continue to grow that. It's a much more steady grower. It has higher gross margins. It has a nice offset on the gross margins, and it's still a very healthy operating margins. I think the value and power of having those two solve some of the things that you worry about in the business model over time.

Liz, Ita, thank you very much for joining us folks, joining our session with Arista Networks.