Arista Networks, Inc. (NYSE:ANET) Q3 2023 Earnings Call Transcript

Arista Networks, Inc. (NYSE:ANET) Q3 2023 Earnings Call Transcript October 30, 2023

Arista Networks, Inc. beats earnings expectations. Reported EPS is $1.83, expectations were $1.58.

Operator: Welcome to the Third Quarter 2023 Arista Networks Financial Results Earnings Conference Call. During the call, all participants will be in a listen-only mode. After the presentation, we will conduct a question-and-answer session. [Operator Instructions] As a reminder, this conference is being recorded, and will be available for replay from the Investor Relations section at the Arista website following this call. Ms. Liz Stine, Arista’s Director of Investor Relations, you may begin.

Liz Stine: Thank you, operator. Good afternoon, everyone, and thank you for joining us. With me on today’s call are Jayshree Ullal, Arista Networks’ President and Chief Executive Officer; and Ita Brennan, Arista’s Chief Financial Officer. This afternoon, Arista Networks issued a press release announcing the results for its fiscal third quarter ending September 30, 2023. If you would like a copy of the release, you can access it online at our website. During the course of this conference call, Arista Networks’ management will make forward-looking statements, including those relating to our financial outlook for the fourth quarter of the 2023 fiscal year, longer-term financial outlook for 2024 and beyond, our total addressable market and strategy for addressing these market opportunities, including AI, customer demand trends, supply chain constraints, component costs, manufacturing output, inventory management, and inflationary pressures on our business, lead time, product innovation, working capital optimization, and the benefits of acquisitions, which are subject to the risks and uncertainties that we discuss in detail in our documents filed with the SEC, specifically in our most recent Form 10-Q and Form 10-K, and which could cause actual results to differ materially from those anticipated by these statements.

These forward-looking statements apply as of today, and you should not rely on them as representing our views in the future. We undertake no obligation to update these statements after this call. Also, please note that certain financial measures we use on the call are expressed on a non-GAAP basis and have been adjusted to exclude certain charges. We have provided reconciliations of these non-GAAP financial measures to GAAP financial measures in our earnings press release. With that, I will turn the call over to Jayshree.

Jayshree Ullal: Thank you, Liz, and happy Halloween, everyone. We delivered revenues of $1.51 billion for the quarter, with a non-GAAP earnings per share of $1.83. Services and software support renewals contributed approximately 16.8% of revenue. Our non-GAAP gross margins of 63.1% was influenced by improving supply chain overheads and higher enterprise contributions. As we have said before, gross margins have consistently improved every quarter this year and will stabilize next year in 2024. International contribution registered at 21.5%, with the Americas at 78.5%. As predicted, Arista’s supply chain and lead times are improving steadily in 2023 and we expect it to normalize in 2024. We are now projecting 33% annual growth versus our prior Analyst Day forecast of 25% growth for the 2023 calendar year.

During the past year, our cloud titan customers have been planning a different mix of AI networking and classic cloud networking for their compute and storage clusters. Our historic classification of our cloud titan customers has been based on industry definition of customers with or likely to attain greater than 1 million installed compute servers. Looking ahead, we will combine cloud and AI customer spend into one category called cloud and AI titan sector. And as a result of this combination, Oracle OCI becomes a new member of the sector, while Apple shifts to cloud specialty providers. This new cloud and AI titan sector is projected to represent greater than 40% of our total revenue mix due to the favorable AI investments expected in the future.

In terms of enterprise momentum, Arista continues to focus on multi-domain modern software with architectural superiority based on our single EOS, Extensible Operating System, and CloudVision stack. This is truly a unique foundation and differentiator. We have demonstrated our strong execution and uncompromised quality with predictable release cadence that our customers have come to enjoy and appreciate. The power of our one consistent software stack across a breadth of use cases, be the WAN routing, campus, branch, or data center infrastructure, is truly unmatched by our industry peers. Let me illustrate with a few customer wins. Our first customer win is an international one where the customer is providing services for their interconnect of high-performance compute, HPC, clusters, which are often its foundation for GPU as a service offering.

Arista’s Ethernet modular switch coupled with EOS created a perfect combination of a phishing platform with real-time telemetry leveraging our EOS state-driven publish/subscribe model. Our next win showcases our expansion of Arista in the public sector with their AI initiative. This grant-funded project utilizes Arista’s simplified operational models with CloudVision. New AI workloads require high scale, high radix, high bandwidth, and low latency, as well as a need for granular visibility. This build out of a single EVPN VXLAN-based 400 gig fabric is based on deep buffer spines and underscores the importance of a lossless architecture for AI networking. This last but not least customer is an example of a campus WAN. Couple of years ago, the customer was looking to do a complete refresh of their aging campus network which comprises of four major headquarter campuses and several remote sites.

The customer was able to leverage the Arista Validated Design models, AVD, all the way from data center into the campus network. The customer chose Arista because they were able to offer best-of-breed operational excellence, as well as security with our zero trust AVA sensors for threat mitigation across the entire campus of wired switches. Arista’s innovative macro segmentation, MSS, combined with Leaf access and core Spine, delivered a compelling two-tier cognitive campus solution. These three customers illustrate our power of the platform and software innovations for a modern network model with a low total cost of operation. We are pleased with our trajectory, setting the gold standard in our industry with the lowest CVEs and vulnerabilities and the highest Net Promoter Score for cloud networking.

And with that, I’d like to hand to Ita, our CFO, for financial specifics.

Ita Brennan: Thanks, Jayshree, and good afternoon. This analysis of our Q3 results and our guidance for Q4 ’23 is based on non-GAAP. It excludes all non-cash stock-based compensation impacts, certain acquisition-related charges, and other non-recurring items. A full reconciliation of our selected GAAP to non-GAAP results is provided in our earnings release. Total revenues in Q3 were $1.51 billion, up 28.3% year-over-year, and well above the upper end of our guidance of $1.45 billion to $1.5 billion. Services and subscription software contributed approximately 16.8% of revenues in the third quarter, up from 15.2% in Q2. International revenues for the quarter came in at $324.7 million, or 21.5% of total revenue, up from 20.9% last quarter.

This quarter-over-quarter increase largely reflected a healthy contribution from our enterprise customers in EMEA and APAC and some reduction in domestic shipments to our cloud titan customers. Overall gross margin in Q3 was 63.1%, well above guidance of approximately 62% and up from 61.3% last quarter. We continue to see incremental improvements in gross margin quarter-over-quarter with higher enterprise shipments and better supply chain costs, somewhat offset by the need for additional inventory reserves as customers refine their forecast product mix. Operating expenses in the quarter were $255.6 million, or 16.9% of revenue, down from last quarter at $287.3 million. R&D spending came in at $164.4 million, or 10.9% of revenue, down from $188.5 million last quarter.

It’s primarily reflected increased headcount more than offset by lower new product introduction costs in the period. Sales and marketing expense was $79 million, or 5.2% of revenue, consistent with last quarter, with increased headcount and some reduction in product demo costs. Our G&A cost came in at $12.1 million, or 0.8% of revenue down from last quarter and reflecting the recovery of some bad debt amounts recorded in prior periods. Our operating income for the quarter was $696.2 million or 46.1% of revenue. Other income and expense for the quarter was a favorable $42.3 million, and our effective tax rate was 21.3%. This resulted in net income for the quarter of $581.4 million, or 38.5% of revenue. Our diluted share number was 317.6 million shares, resulting in a diluted earnings per share number for the quarter of $1.83, up 46.4% from the prior year.

Now, turning to the balance sheet. Cash, cash equivalents and investments ended the quarter at approximately $4.5 billion. We did not repurchase shares of our common stock in the quarter. To recap our repurchase program to date, we have repurchased $855.5 million, or 8 million shares, at an average price of $107 per share, under our current $1 billion Board authorization. This leaves $144.5 million available for repurchase in future quarters. The actual timing and amount of future repurchases will be dependent on market and business conditions, stock price, and other factors. Now, turning to operating cash performance for the third quarter. We generated approximately $699 million of cash from operations in the period, reflecting strong earnings performance combined with some increase in deferred revenue and taxes payable.

DSOs came in 51 days, up from 49 days in Q2, reflecting the strong collections quarter and a good linearity of billing. Inventory turns were 1.1 times, down from 1.2 last quarter. Inventory remains flat to last quarter at $1.9 billion, reflecting the ongoing receipt in consumption components from our purchase commitments and an increase in switch-related finished goods. Our purchase commitments at the end of the quarter were $2 billion, down from $2.2 billion at the end of Q2. We expect the overall purchase commitment number to continue to decline as we further optimize our supply positions. However, we will maintain a healthy position related to key components, especially as we focus on new products. Our total deferred revenue balance is $1.195 billion, up from $1.085 billion in Q2.

The majority of the deferred revenue balance and services related and directly linked to the timing and term of service contracts, which can vary on a quarter-by-quarter basis. Our product deferred revenues balance increased by $47 million from last quarter. Accounts payable days were 44 days, down from 57 days in Q2, reflecting the timing of inventory receipt payments. Capital expenditures for the quarter were $11.2 million. Now, turning to our outlook for the fourth quarter. Customer planning horizons for new deployments have shortened in concert with steadily improving lead time. On the supply side, we expect to continue to ship against previously committed deployment plans for some time, targeting supply improvements where most needed, but also careful not to create redundant customer inventory.

As outlined in our guidance, we expect to make incremental improvements to our 2023 outlook, which now calls for year-over-year revenue growth of approximately 33%. On the gross margin front, we expect gross margins of approximately 63% in the fourth quarter, reflecting ongoing supply chain and manufacturing benefits while maintaining a reasonably healthy cloud contribution. Turning to spending and investments, we expect to monitor the overall macro environment carefully while engaging in targeted hiring in R&D and go-to-market as the team sees the opportunity to acquire talent. On the cash front, while increases in working capital has begun to moderate in recent quarters, our year-to-date 2023 tax payments have been deferred to October, and this will represent a significant incremental use of cash in the fourth quarter at approximately $352 million.

With all of this as a backdrop, our guidance for the fourth quarter, which is based on non-GAAP results and excludes any non-cash stock-based compensation impacts and other non-recurring items is as follows: revenues of approximately $1.5 billion to $1.55 billion; gross margin of approximately 63%; operating margin of approximately 42%; our effective tax rate is expected to be approximately 21.5%, with diluted shares of approximately 319 million shares. I will now turn the call back to Liz. Liz?

Liz Stine: Thank you, Ita. We will now move to the Q&A portion of the Arista earnings call. To allow for greater participation, I’d like to request that everybody please limit themselves to a single question. Thank you for your understanding. Operator, take it away.

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Q&A Session

Operator: We will now begin the Q&A portion of the Arista earnings call. [Operator Instructions] Your first question comes from the line of Samik Chatterjee with JPMorgan. Your line is open.

Samik Chatterjee: Hi, thank you for the question, and congrats on the results. I guess just to keep it simple, Jayshree, if you can give us an update on when we think about the last 90 days, how have the two sort of verticals, cloud titans and enterprise, sort of shown up in terms of momentum of orders and demand relative to where your expectations were 90 days ago? I know some of the cloud companies have talked about their CapEx outlook for next year as well. So, an update on that would be helpful. And on the last call, you did talk about a target for double-digit growth next year. So, how are you thinking in relation to that number still going into the Investor Day? Thank you.

Jayshree Ullal: Okay. Thanks, Samik. First of all, we are looking forward to sharing more detail on Analyst Day. But just to reiterate, our team has always projected at least a double-digit growth for next year and years beyond. So that goal remains unchanged. And we’ll share more with you. Coming back to the last 90 days, as you know, as our lead times improve, our visibility declines. But we don’t see significant change in improvements or declines in the last 90 days. We continue to see good momentum on enterprise and we continue to see a good expected push on the combination of both cloud and AI together.

Samik Chatterjee: Okay. Thank you. Thanks for taking my question.

Liz Stine: Thanks, Samik.

Operator: Your next question comes from the line of Antoine Chkaiban with New Street Research. Your line is open.

Antoine Chkaiban: Thanks very much for taking my question. So, accelerated AI cluster deployment is clearly waiting on traditional infrastructure deployment this year. And I’m keen to hear how sustainable you think this is, because the vast majority of workloads still run on traditional infrastructure, right? So, is it fair to expect a rebound in traditional infrastructure spend next year?

Jayshree Ullal: Yes, thank you, Antoine. I’ll share some of my thoughts and I’d like to hand it over to Anshul for further thoughts. We’ve always looked at the cloud network as a front-end and a back-end. And as we said last year, many of our customers are favoring spending more on the back-end with AI, which doesn’t mean they stopped spending on front-end, but they’ve clearly prioritized and doubled down on AI this year. My guess is as we look at the next few years, they’ll continue to double down on AI, but you cannot build an AI back-end cluster without thinking of the front-end. So we’ll see a full cycle here where, while today the focus is greatly on AI and the back-end of the network, in the future we expect to see more investments in the front-end as well.

Anshul Sadana: Jayshree, that’s right. You said it’s spot on. AI is everyone’s priority right now, and the rest will get touched at the right time.

Antoine Chkaiban: Thank you.

Liz Stine: Thanks, Antoine.

Operator: Your next question comes from the line of Matt Niknam with Deutsche Bank. Your line is open.

Matt Niknam: Hey, thank you for taking the question. One question, very simple one, on services. Pretty nice improvement, about 13% sequential improvement in the quarter. Seasonally, I think we’ve seen low-single digits, mid-single digits. Anything you would call out? And how are we thinking about that for the fourth quarter? Thanks.

Ita Brennan: Yeah, look, I think every now and again you see kind of a pop on the services line. It’s usually either somebody has consumed services faster than they intended to or we’ve been negotiating a contract and then when we do actually finally sign the renewals contract, there’s some flush of prior periods into the quarter. So, if you look back historically, you’ll see that happens from time to time. I don’t think it changes the kind of fundamental growth and services we’ve talked about that’s kind of mid to maybe a little bit higher teens growth on an ongoing basis year-over-year. I don’t think it changes that. It’s just you do have these little spikes from time to time.

Matt Niknam: Thank you.

Liz Stine: Thanks, Matt.

Operator: Your next question comes from the line of Karl Ackerman with BNP Paribas. Your line is open.

Karl Ackerman: Yes, thank you. I suppose this is a question for Ita, but is the upside in the quarter an outlook coming from a combination of better bookings and working down some of your prior backlog? Just any thoughts in terms of maybe where your backlog may end up relative to normal levels pre-pandemic would be super helpful. Thank you.

Ita Brennan: Yeah, Karl, we don’t talk about backlogs, specifically. I think what we have said is, as lead times improve, you expect to see some reduction in visibility [because] (ph) customers, the time where they have to pay orders changes over time, right? So I think that we are seeing that dynamic, we’ve talked about that dynamic that we are — as lead times get better, we are seeing kind of customer planning horizons are shortening. We will be still deploying, if you listen to my prepared remarks, I mean we are still deploying equipment into next year from plans that we made some time ago, and that’s just kind of again working with customers and laying out their plans. But in terms of giving specific numbers, we haven’t done that.

Liz Stine: Great. Thanks, Karl.

Operator: Your next question comes from the line of Amit Daryanani with Evercore. Your line is open.

Amit Daryanani: Good afternoon, everyone, and congrats on a nice set of numbers here. I was hoping you could talk a little bit more on the enterprise side. You’re seeing some really good strength over here clearly. But maybe you can talk about, is the strength more coming from campus versus the data center side, maybe just qualitatively where you’re seeing better trends? And really the context of this is I think a lot of your peers are seeing a very severe drop in their growth rates as their backlogs have gone away. You don’t seem to be having that issue. So I’m wondering like what is the offset to that and what’s enabling the growth? And to the extent, you can talk about campus versus the data center that would be really helpful. Thank you.