Arista (ANET) reported Q3 results above expectations. The 28.7% revenue growth and stable margins YoY lead to a GAAP EPS increase to $2.08.

At this pace, the company is taking Market share in the cloud data center area. These results contrast with the difficulties some other network vendors highlighted during the last few quarters.

With a strong Q4 guidance and with the optimism management expressed during the Earnings call, the market values the company at a premium. The $263 stock price implies a PE ratio ex-cash of about 39. With my discounted cash flow model, I value the company at about $212/share.

Impressive Q3 earnings

Arista continues to impress with results exceeding the guidance. Revenue, at $563.3 million, grew by 28.7% YoY despite a tough comparison with Q3 2017.

The GAAP gross margins and operating income stayed stable YoY at 64.2% and 32.1%.

As a result of growing sales and stable margins, diluted GAAP EPS kept on growing to $2.08. The graph below shows the non-GAAP EPS growth over the last 8 quarters.

Source: Q3 2018 presentation

Growing market share

These developments contrast with the difficulties Juniper (JNPR) and Extreme Networks (EXTR) expressed in the cloud networking area. And Arista keeps on taking market share in the cloud area from Cisco (CSCO).

Source: Q3 2018 presentation

Despite concerns about the reduced spending of cloud providers, management still sees a healthy market:

We don’t see any near-term signs of that changing nor the predicted concerns. It is true that we don’t track one-to-one with their cloud CapEx. And remember now that despite the lumpiness of the Cloud Titans, and we have many of them, we are comfortable with the continued spend because there are multiple use cases. And we expect this to continue this quarter and early 2019, given our typical two-quarter visibility.

– Jayshree Ullal, CEO

Source: Q3 2018 earnings call

And with the strategy of expanding the success of the cloud data center to the campus, management communicated encouraging early signs.

Since our last update, we have introduced the X3 Spline as we call it. This is used both in campus use cases and in data center cases, comes in a modular and fixed form factor, and that has been very well received and is in early trials in the campus. Customers are excited about that.

– Jayshree Ullal, CEO

Source: Q3 2018 earnings call

It is too early to predict that Arista will gain market share the same way as the company did in the cloud data centers, though. The company still can’t offer a complete campus solution due to its limited portfolio.

The tariff decisions don’t seem to affect the competitive landscape. Arista adopted the same strategy as Juniper. While trying to mitigate the consequences by adapting the supply chain, the company will pass a part of the costs to the customers. And management indicated gross margin would stay in the standard range of 63% to 65%.

There were also a lot of discussions around the 400-gig developments during the earnings call. But I don’t see any competitive advantage for any network vendor with this development. Cisco and Arista announced during the last week of October the coming release of 400-gig switches. While Cisco claimed the availability of these switches during H1 2019, Arista spoke about deployments during H2 2019:

While we are very excited about the 400-gig growth opportunity, we do expect to see a lot of 400-gig qualification activity in the first half of 2019, with initial 400-gig production deployments in the second half. The 400-gig ramp in 2019 is also constrained by the volume availability of 400-gig optics, which so far are only available in prototype quantities.

– Andy Bechtolsheim, Chairman

Source: Q3 2018 earnings call

Juniper communicated in July about the ramp-up of its 400-gig switches during 2019.

In any case, the main network vendors seem to propose a commercial 400-gig offer during 2019. A few months difference for the release of these products will not make any difference in terms of market share.

Valuation

The Q4 revenue guidance indicates a range of $582 million to $594 million. For the valuation, I assume the mid-point of the guidance, which results in revenue growth for the FY 2018 of about 30%.

I assume a GAAP operating margin of 30% and a 21% tax rate. Thus, my estimation of GAAP net margin amounts to 23.7%.

Source: author, based on company reports

Even if Arista is a great company, a PE ratio of about 39 values the company at a premium.

The table below presents my estimations of the stock price based on my following assumptions:

• Between 2018 and 2022, the revenue CAGR amounts to 25%.
• Net margin stays the same as my FY 2018 estimation: 23.7%.
• For the earnings after 2022 to perpetuity, I apply a multiple between 13 and 18, which is one of the two variables of the table below.
• The other variable is the discount rate I apply to the earnings, between 7% and 11%.
• The model takes into account the cash position and shares outstanding at Q3 2018 to calculate the stock price.

Source: author

The table shows we need to apply a 7% discount rate and a multiple of 18x to the earnings beyond 2022 to justify a stock price of $261.

Considering the profile of the company, I prefer to apply an arbitrary discount rate of 9%. I chose a 15x multiple to the earnings after 2022 to arrive at an estimation of a fair stock price at $212. The $212 stock price corresponds to a PE ratio ex-cash of about 30.

Conclusion

Arista again exceeded expectations with Q3 revenue growth of 27.8% YoY. The company is taking market share from other network vendors, including Cisco. These results contrast with the difficulties Juniper and Extreme Networks reported in the cloud data center market.

The tariff decisions and the developments related to the 400-gig switches don’t affect the competitive landscape. Management is optimistic and guided on strong Q4 revenue growth.

As a result, the market values the company at a high PE ratio ex-cash of about 39 (with the stock price currently at $263). With my discounted cash flow model, I estimate a fair price of about $212/share, which corresponds to a PE ratio ex-cash of approximately 30.

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Disclosure: I am/we are long CSCO.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.