Ticker: ANET
Stock exchange: Nasdaq
Price: $212
Fair value estimate: $190
Recommendation: Buy
The emergence of Artificial Intelligence (AI) is primarily facilitated by data centers operating within the cloud architectural framework: compute, storage, and networks. In the realm of computing, Nvidia stands out as a dominant force. Recently, I evaluated potential contenders in the storage sector and identified Pure Storage as an undervalued option poised for stock price growth {storage]. When it comes to networking, while Cisco holds a prominent position globally, its ability to capitalize on the AI revolution appears limited. In contrast, Arista Networks (ANET), a disruptive player in the networking industry, arises as a frontrunner.
Overview
ANET describes itself as an industry leader in data-driven, client-to-cloud networking for large data centers, campuses, and routing environments. The company was founded in 2004 by the networking gurus Andreas Bechtolsheim, David Cheriton, and Kenneth Duda It has steadily gained market share with a focus on high-performance computing and high-frequency trading environments. ANET counts Microsoft and Meta Platforms as its largest customers and derives roughly three-quarters of its sales from North America. The company headquarters is in Santa Clara, California, and has around 2600 employees. Its market capitalization is close to $66 Billion.
To the moon!
It seems the market has recognized the potential for ANET to significantly expand its market share due to the rise of AI. The third-quarter 2023 report showcased impressive results, surpassing expectations in both revenue and profits. In recent days, it looks like ANET is challenging gravity as exhibited by the one-year chart below.
Short explanation: networks, switches, and routers.
A computer network is a system that allows multiple devices to communicate with each other, share resources, and access the internet. Switches connect devices within a network, while routers connect multiple networks, enabling communication and resource sharing between them. Both devices play crucial roles in the functioning of a modern computer network.
ANET offers products and solutions that cover the entirety of the network industry. However, the company is best known for its high-speed switches, the communication tool that AI cannot function without. It is this capability that drives the current explosive top-line growth.
Arista 7800 AI Spine
One common characteristic of AI workloads is that they are both compute and data-intensive. They often involve sparse metrics computation so large that the parameters must be distributed across thousands of processors. Each processor calculates intensely for a period and then shares its results with the others in a burst, and each of them merges its peer's data with the local data, and then another round of computation begins, as visualized in the figure below. The volume of data exchange in these cycles is huge, a slowdown in the network can severely hamper the runtime, and as the problem sizes get bigger, it becomes imperative for application performance to accomplish wire-rate delivery of large synchronized bursts of megabytes to gigabytes of data.
The path from seven to five to three-nanometer silicone for networking is something ANET has ridden from 100 to 400, and further to 800 gigabits per second. The ideal network for AI applications is this lossless fabric that can interconnect thousands of processors at wire speed.
For the best performance at scale, ANET has the Arista 7800 AI Spine, a high-speed switch that delivers hot-spot-free load balancing, internally congestion-free PFC to ensure lossless delivery, exceptional flexibility for buffering tuning, a single chassis that can connect 575 GPUs at 400 GBps, and it gots industry-power-beating-per-gigabit.
It is the Arista 7800 AI Spine series that is making ANET the industry leader in AI networking. Besides this crucial component, Arista has a whole ecosystem of networking features that enforce its total value proposition among large data center vendors and enterprises.
The Extensible Operating System (EOS)
EOS is ANET's cloud network operating system. The system is fully programmable and highly modular, using a Linux-based network operation system. It is designed to control networking platforms that scale data centers supporting thousands of 10G plus ports in a high-performance, fault-tolerant network. EOS is programmable at all layers, including the Linux kernel, hardware forwarding tables, switch configuration and CLI, switch control plane, and management layer. It provides a rich set of APIs that use standard and well-known management protocols, enabling rapid integration with a wide range of third-party applications for virtualization, management, automation, orchestration, and network services. EOS is optimized for demanding environments such as hyper-scale data centers, large campuses, multi-cloud connectivity, and carrier networks. EOS is also offering state-of-the-art visibility and telemetry, an increasingly important aspect of cloud computing highlighted by Cisco’s purchase of Splunk [cybersecurity giant].
On top of these capabilities, ANET’s EOS supports critical network functions in support of AI processes, including flexible load balancing for Elephant flows, priority flow control and ECN marking to support RDMA, QOS to prioritize latency-sensitive control packets, and advanced monitoring of latency, PFC, and drops.
EOS Network data lake (NETDL)
In 2021, ANET introduced its third version of its EOS stack architecture: the Network data lake. NETDL is designed not only to gather networking data but also the networking state, enrichment data from all the systems around it, digital experience moderating data, and 3rd party data into a common multi-modal, multi-tenant data lake architecture. This enables a broad ecosystem of partners to interact on top of this data and becomes a foundation for applying AI and machine learning applications within the network.
In summary, we can, therefore, conclude that Arista has built a network architecture that is AI-ready, giving the company a huge competitive edge.
Valuation
My DCF valuation gives ANET a fair value estimate of $190. I reach this value by telling the following story. There is a sound proposition to assume that the sales growth is going to be gang-busters in the next three years. However, we have to take into account that enterprise spending on networking resources has some cyclicality to it. Thus, I have incorporated a temporary slowdown in growth for 2027, anticipating a quick rebound in the subsequent year. In my reasoning, the downturn is not going to last long and be very deep, given ANET’s strong value proposition and since it also sells services attached to its products, which account for about 20 % of its total revenues. From 2028 I have factored in a growth that is a bit stronger than Cisco’s current trajectory.
While my financial model suggests ANET may be slightly overvalued, it's crucial not to underestimate the demand for ANET's products amid the ongoing AI revolution. There's a possibility that ANET could outpace my current growth projections in the near term. It's also important to recognize the market's tendency to assign high valuations to companies experiencing explosive growth. Additionally, we should note that ANET's stock price is highly sensitive to changes in interest rates. Even a 1% decrease in the cost of capital could significantly boost the company's per-share value by nearly $50. I would not be surprised if ANET's stock price doubles from today’s level at a certain point in the upcoming years.
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