We recently compiled a list of the 10 Best Cloud Stocks To Buy According to Short Sellers. In this article, we are going to take a look at where Arista Networks, Inc. (NYSE:ANET) stands against the other cloud stocks.
The cloud computing market is one of the fastest growing in the technology industry as the ubiquity of the internet allows business to digitally outsource their functions to reduce investment costs and access specialized services. Estimates show that the cloud computing market was worth $480 billion in 2022, and despite its heft, it is expected to grow at a compounded annual growth rate (CAGR) of 17% to be worth a whopping $2.2 trillion by the end of 2032. The three segments of the cloud computing industry are infrastructure as a service (IaaS), software as a service (SaaS), and platform as a service (PaaS).
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This market, like other mega technology industries, is dominated by mega cap technology companies. As per research from Gartner, the global IaaS market is dominated by five services as of 2023 end. These are AWS, Azure, Google Cloud, Aliyun, and Huawei Cloud. Their market shares are 39%, 23%, 8.2%, 7.9%, and 4.3%, respectively, with all other firms commanding 17.6% of the total market. In terms of revenue, AWS raked in an impressive $54.6 billion in revenue, while the others brought in $32.1 billion, $11.4 billion, $11.1 billion, and $5.9 billion, respectively. AWS’ dominance in the industry is clear as it brought in more than twice the revenue of all other firms that follow Huawei since their cumulative revenue was $24.6 billion.
Apart from the biggest players, whose valuation metrics are different due to their mature and diverse business models, valuing cloud computing stocks is different from how you’d value other companies. For instance, most firms are valued through their price to earnings (P/E) ratio. This measures the premium that investors are willing to pay for a firm’s earnings, but the ratio becomes useless when we try it to value cloud computing stocks. This is because of the industry’s obsession with growth, and its need for high margins, meaning that cloud cloud computing stocks, and particularly SaaS stocks, reinvest large portions of their revenue back into growth.
So much so that one of the most troubled SaaS companies these days has been aggressively investing in growth despite its shares being down 39.65% year to date. This firm ranks 6th on our list of Ray Dalio’s Top 10 Growth Stock Picks with 30+% Revenue Growth, with its second quarter product revenue of $868.8 million marking a 28.9% annual growth. However, this growth clearly hasn’t been enough, as the stock tumbled by 14.7% after the latest earnings report. During the same period, this firm’s marketing and research and development expenses sat at $838.2 million, or 96% of its revenue. This is a classic illustration of the cloud computing industry, and one that requires different valuation metrics than the P/E ratio as these firms are not profitable most of the time.
The two key metrics for valuing SaaS stocks in particular are the EV/Revenue and the Rule of 40. A firm’s enterprise value is its market value plus net debt, and when divided by revenue, the resulting ratio measures the premium that a buyer would be willing to pay for a firm over its ability to generate revenue. The Rule of 40 is simpler, as it simply states that the sum of a SaaS firm’s revenue growth rate and profit margin should exceed 40. While this rule is simply a benchmark and not all inclusive of SaaS performance, it does have some key implications. For instance, it implies that if a firm is growing its revenue at or faster than 40%, then it can be unprofitable.
On the flip side, if growth slows down, to say 10%, then it must be highly profitable with margins of at least 30% to show that the lower growth is accompanied by the benefits of the beefy margins that software companies enjoy. McKinsey also substitutes the profit margin with the free cash flow (FCF) margin to further broaden this rule’s scope. A firm’s FCF simply eliminates the impact of interest, taxes, and capital expenditure on the net income. As per its analysis, the top Rule of 40 SaaS companies are investor favorites. This is because McKinsey’s data shows that in a sample size of 100 SaaS companies, those with the 25 highest Rule of 40 scores had median EV/Revenue multiples of 22. This was nearly 22x the overall sample’s 11x, and nearly 3x the bottom 25 firms’ median EV/Revenue multiples of 8. In other words, investors are typically willing to pay a higher premium over sales for SaaS firms that have either robust revenue growth, superior cost control, or a mix of both.
Finally, while EV/Revenue and Rule of 40 measure the financial validity and stature of these firms, their stock performance is also tightly linked to the economy and monetary policy. A low interest regime means that businesses can spend more money, which is beneficial for SaaS and cloud computing firms, both. On Wall Street, August has marked a paradigm shift after Fed Chair Jerome Powell confirmed that his organization was satisfied with macroeconomic indicators to cut interest rates. This has also impacted valuations, as the median EV/Sales ratio for the top companies, i.e. Rule of 40 firms with a growth rate higher than 30%, sat at 13.3x as of the latest market close. This is the second highest for the year, with the last high being in May when it sat at 16.3x. This was before a brief rate gloom took over Wall Street in July which saw the flagship S&P index lose 8.5% between mid July and early August.
Any discussion of SaaS stocks would be incomplete without a brief discussion of the implications of artificial intelligence. According to hedge fund Coatue Management, SaaS valuations as measured by forward sales are at a historic low right now through a median of 5.5x. This comes with lower growth expectations, as just 1% of SaaS firms are now seeing a median forward growth estimate of 30%+. As for the business model, SaaS firms are seeing a shift from a traditional seat based model that drove revenue from the number of users that were using the services to a consumption driven model. Their lower growth expectations are also somewhat driven by the belief that AI could allow companies to cost effectively create their own code and thereby reduce their reliance on SaaS and cloud computing providers.
Our Methodology
To make our list of the best cloud stocks to buy according to short sellers, we ranked the holdings of First Trust’s cloud ETF by the percentage of shares outstanding that were sold short. Then, the stocks with the lowest percentage were selected.
We also mentioned the number of hedge funds that had bought these stocks during the same filing period. Why are we interested in the stocks that hedge funds pile into? The reason is simple: our research has shown that we can outperform the market by imitating the top stock picks of the best hedge funds. Our quarterly newsletter’s strategy selects 14 small-cap and large-cap stocks every quarter and has returned 275% since May 2014, beating its benchmark by 150 percentage points (see more details here).
A technician in a server room managing a large-scale network of computers.
Arista Networks, Inc. (NYSE:ANET)
Number of Hedge Fund Investors in Q2 2024: 65
Short Interest as % of Shares Outstanding: 0.83%
Arista Networks, Inc. (NYSE:ANET) operates on the hardware side of the cloud computing industry. It sells products such as routing systems and switches, and the firm also offers its own software products. While the software and end use phases of the artificial intelligence stack might take longer to generate revenue, the hardware side is seeing booming demand as evidenced by NVIDIA’s share price. This has also translated into robust share price performance for Arista Networks, Inc. (NYSE:ANET), as the stock is up 86% over the past 12 months. Another key advantage that Arista Networks, Inc. (NYSE:ANET) has enjoyed over other hardware firms is its operating system that manages data centers and other systems. This works in tandem with its network switches, and Arista Networks, Inc. (NYSE:ANET) enjoys a considerable presence in the ethernet market. However, the firm is facing competition from AI giant NVIDIA for its ethernet and Infiniband products, and as its software is tailored to non AI use cases, Arista Networks, Inc. (NYSE:ANET) remains vulnerable to a competitor taking its share in the AI market.
Artisan Partners mentioned Arista Networks, Inc. (NYSE:ANET) in its Q2 2024 investor letter. Here is what the fund said:
“Arista Networks is the market leader in cloud networking equipment used in data centers. Shares have experienced strong outperformance since the beginning of 2023 due to its ethernet options being well positioned to capture market share in AI cloud environments (more scalable and cheaper than InfiniBand, an out-of-the-box solution by Nvidia). Similar to Chipotle, after a period of strong performance, we trimmed the position based on valuation and market cap.”
Overall ANET ranks 6th on our list of the best cloud stocks to buy according to short sellers. While we acknowledge the potential of ANET as an investment, our conviction lies in the belief that some AI stocks hold greater promise for delivering higher returns and doing so within a shorter timeframe. If you are looking for an AI stock that is more promising than ANET but that trades at less than 5 times its earnings, check out our report about the cheapest AI stock.
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Disclosure: None. This article is originally published at Insider Monkey.