Arista Networks, Inc. (NYSE:ANET) Morgan Stanley Technology, Media and Telecom Conference 2022 March 8, 2022 2:30 PM ET
Company Participants
Ita Brennan – Chief Financial Officer
Conference Call Participants
Meta Marshall – Morgan Stanley
Meta Marshall
All right. Welcome, everybody. I’m Meta Marshall, I cover the networking space here at Morgan Stanley. And we’re delighted to have Ita Brennan here today. CFO of Arista Networks. I want to start with a brief disclosure for any important disclosures, check morganstanley.com/researchdisclosures or talk to your sales representative. Ita, welcome.
Ita Brennan
Thank you.
Question-and-Answer Session
Operator
[Operator Instructions]
Meta Marshall
What, I want to start by diving into is there’s been this debate over the past couple of years about your relevance, was it capped at 100 gig and you wouldn’t find as much kind of relevance to your cloud customers at 200 gig and 400 gig, then clearly, we’ve seen that the opposite is true. Can you just kind of go into whether there’s been a shift in how partners are or how your customers are looking to partner with you? And how this kind of upgrade cycle is a little bit different?
Ita Brennan
Yes, I think look, it all goes back to, and we’ve been partners with these companies for, many product generations at this stage, right and for a very long time. And the good thing about it is it’s all an engineering led, right? These are technical buyers, their engagement is at an engineering level, whether we’re solving problems for two generations out or we are solving problems, kind of for, current problems in the network today. But there’s this great collaboration at the engineering level that really drives that kind of recurring stickiness in the business, right. And there’s lots of changes from, architecture, decisions perspective, getting forward looking and current that we engage with these customers on and help contribute to those decisions in those discussions.
And that’s part of that collaboration that I am so proud about with these customers, right, and making sure that, we’re bringing kind of our expertise to the table to help kind of not only kind of be part of the product solution, but obviously be part of determining what that roadmap looks like what that architecture looks like going forward, that I think that’s the key to, being able to kind of anticipate some of the changes that are happening from a technology perspective, maybe lead some of those changes, and be able to participate in a meaningful way on a recurring kind of cycle basis.
So for us, 400 gig wasn’t that different. I mean, a lot of the discussions around 400 gig were happening, 300 gig shipping in volume, right? I mean, it’s that long in terms of the lead in, now you’re talking about 800 and beyond, at that level of those conversations, right. So I think that’s key is that collaboration, from a technical perspective, that a sharing of ideas, that kind of the trust that’s between those engineering organizations, is a big part of kind of this collaboration over time.
Meta Marshall
Got it. I mean, when people hear about Sonic, or they hear about different initiatives, they often think like, oh, they’re trying to internalize certain functions. And I guess what, how do you see some of those efforts by kind of some of your web scale customers to internalize versus like, where that creates even more opportunity for you guys?
Ita Brennan
Yes, I mean, I think all of their focus all the time is to make it better and make their operations scale, right, they’re growing, they’re still growing, and they’re still expanding, kind of what they do. So the focus is really on making it more efficient, making it scale better. So we’ve always been very supportive of that, right, whether, it was kind of switch routing platforms, whether it was some of their own internal work that they wanted to do. Our approach has always been to support that, because really, what it’s driving to is a more efficient network that lets them scale and do more. Right. And as long as so we’ve found over time repeatedly, right? That supporting those internal efforts, helping kind of accelerate them in some cases, support them, in other cases just exposes us to even more, and because of the nature of their business, and how that business is growing. There’s always something new for us to go do or a new use case for us to go solve and that network and so that approach has worked very well.
So I think, it’s a compliment, Anshul and Jayshree and how they think about the customer, but really, when you support the customer in these efforts. It’s just an expo — every time it’s exposed something new, right.
Meta Marshall
Got it, I mean, to speak of something new or expanding opportunities, you clearly have a fair amount of deferred revenue right now, that’s kind of tied to some of these projects. Can you just kind of help level set? Is that multiple projects is that some of the expansion that you’re talking about? Just how we should think about some of that deferred revenue coming off over the next year or being recognized?
Ita Brennan
Yes, it’s pretty typical. When we have like a new product set of products like you saw 100 gig was, we’ll see — we’re seeing it again, now at 400 gig, just as you deliver kind of these platforms at scale early in that cycle, there would be some acceptance associated with that to give them an opportunity to really deploy in their environment. It’s very hard to pre kind of call some of that just because you don’t have environments of that scale to test in so it’s pretty difficult for us to build a deferred revenue balance at this time of product revenue, we said it’s largely cloud related at this point and it’s multiple customers, it’s not just a particular use case, I think what you’ll see happen is those will cycle within that balance. So we were not, we haven’t assumed any decline in the balance year-over-year. When we think about the 30% growth case, but it will cycle there’ll be things that will be accepted, and then some new dollars will go into that as we go through the year.
Meta Marshall
Got it. And maybe moving away from the super large cloud guys right now. Your Tier 2 and specialty cloud providers’ revenue accelerated last year as well. What are you seeing and maybe a change in behavior in these customers in terms of building their own network versus leveraging cloud? Just are you seeing kind of a desire to control their own networks or just anything on their behavior?
Ita Brennan
Yes, I mean, we’ve come through a period, if you think back to kind of era of end of ‘19, into the beginning of 2020, where a lot of those players were rationalizing kind of what they were going to do themselves versus what they would put in the cloud. And so we saw some volatility, honestly, in our business with them in that timeframe. But now having kind of right sized, what they want to control for themselves, and found kind of where they’re competitive, where that brings them some competitive advantage, we are seeing that those footprints grow, right. And we saw that last year, that piece of business grew nicely last year, they will also look to leverage the new, newer products and new technology. So we’d expect to see some continued kind of growth around that, right. So that’s specialty cloud customers will tend to be customers who reach a point where they really start to evaluate whether, what they want to control themselves, cost structure wise, what’s better to kind of control and have themselves versus what’s in the public cloud. And I think we see that pattern of kind of you get to a certain scale and size where you start to really think about that, and then you kind of resolve that and then grow the pieces that that you maintain for yourself.
Meta Marshall
Got it. I mean, did their buying patterns really different? Differ from what we would see with other customer size, is it more project based just anything?
Ita Brennan
I mean, it’s technology, I think there’s some linkage to technology, for sure. I mean, they will want to follow or be on par with kind of what hyper scale customers are doing from a technology perspective. So a little different maybe to enterprise, they’ll probably be more aggressive around following the technology, than maybe what you’d see from an enterprise customer.
Meta Marshall
Got it. Maybe also turning into the service provider side, this has maybe been an opportunity that’s taken longer to develop kind of than maybe you wanted to, but it still managed to be quite a good business for you guys. What do you see as a catalyst there for kind of more faster changes for their networks? Is it 5G? Are there kind of core network upgrades that we could think to as creating opportunity for you guys?
Ita Brennan
Yes, I mean, that has been very much a use case, kind of where you can find a fit to like a telco cloud, like architecture, we do very well, right. And then we’ve been growing, where we deployed and as good customer acceptance, and it grows, right? It’s really what — how do you expand kind of the parts of the network, they are going to be service with that cloud architecture over time, because we haven’t gone back and builds every feature that would require me to go compete for kind of the existing infrastructure, right. So it’s really, what can drive more cloud like architectures for them, I think, 5G, ultimately will do that, there’ll be more, initially, it’s kind of at the front end of the design, but once it gets to kind of aggregation and managing kind of the aggregated traffic from that, that’s likely to be more of a telco cloud like architecture. And that’s where we can compete and hopefully that helps, right, but it’s really, the more that there are networks wants to look more like a cloud network, I think that gives us a real opportunity to do something compelling for them. It’s just that signal. That’s taken a long time. And we’re still looking for those insertion points, right. So I think that’s the go forward is more can you find customers that are ready to make the move to that more cloud based architecture? When they are I think, then we can compete well for that business.
Meta Marshall
Got it. Moving on to enterprise, you’ve done quite well here and they’re now kind of expanding the offerings into campus. Just where are you seeing kind of the, I think there’s a fair amount of runway for you guys with existing customers, but just how do you think about kind of growing out that sales channel or expanding the campus business and is there a revenue threshold that we should think of when it’s like, okay, this is no longer just attached to existing customers.
Ita Brennan
Yes. I mean, even today, I think Jayshree covered it on the call, I mean in the Q4 for kind of new logos for campus, there was probably 50% that were not existing Arista customers, right. So there is no, we are seeing kind of still in that large enterprise part of the market, which is probably close to 50% of the overall campus market. But accounts where we didn’t have a datacenter footprint before, right. So we are seeing both of those drivers, right, it’s still a direct sales motion to get to the customer. But there’s an equal desire, I think, on the part of large enterprises that’s been very much a single vendor sale previously. So having somebody else bring, a quality solution there, we do see good interest in evaluating the risks. And those cases as well, even if they’re not already deployed to the data center, and some of those will have data center footprint, some of them won’t. Obviously, if they do have a data center footprint, it’s a good cross sell. But in any case, a large enterprise will have some meaningful campus business that we would pursue in a direct sales model.
Meta Marshall
And, I mean, is there a point where you would kind of expand the sales model to be less direct? Or just how do we think about that developing?
Ita Brennan
Yes, and we’re doing that we’re working on doing that right, again, not to solve for the near term goals, but to start to build kind of some momentum for the mid-market, part of that overall market, right. And that will take some time. I mean there’s no doubt that we will need to find partners build, build a business with those partners, and have them be successful. And the more we expand kind of our enterprise business, which we’re doing, the easier it will become to kind of to adopt partners for that campus business, but it’s still going to take time, right? So we’re fortunate that we have kind of this large enterprise time to go chase force. But at the same time, we need to be making some progress on the indirect as well.
Meta Marshall
I think one of the questions that I haven’t run into, in my own mind, is the buyer for the data center being kind of different and maybe more sophisticated than your traditional person managing that campus network. And so is the value proposition of EOS and the simplicity still the same to a campus buyer? Or does — how does that sales messaging differ from data center to campus?
Ita Brennan
I think at some point, that was true, right? It’s become less true, I think the more that you have different devices, different entry points to the network, more complexity around this whole hybrid work. Use IoT use and buzzwords. But it’s like the more kind of complexity there is in that campus network. The more people working hybrid models, et cetera, the more important it becomes just sustained business. I think you are seeing a real interest again, in technology around that, whether it’s just the management of that the security of that, the visibility to that. So I think you’re right, if you think about go back in time, we weren’t that interested in the campus market honestly because it was very static, right, it was, it had the technology it had, and there wasn’t a lot of churn. And there wasn’t a lot of new technology. But now there’s a lot of new investment happening around the campus. And there’s also a refresh happening in the technology. So it’s a good time to be looking to insert into that campus network.
Meta Marshall
Okay, perfect. Are there areas where either your resellers, I was trying to get a sense of security has been an area, obviously that a lot of networking guys have gotten into, and you guys have had select purchases, but have largely chosen to partner? Just what has kind of informed that decision to partner more versus kind of have that in house?
Ita Brennan
Yes, I mean it’s going to come back to, I guess, the tradeoff between focus and really being able to drive differentiation, right. So when you think about the Awake acquisition, for example, right. I mean, that was — it was a first step to say, we would like to have more security expertise in the team, because we think kind of securing the network is becoming more and more important, and more complex, right? So what we’re, I think we just announced last week, kind of our first kind of integrated integration between the Awake, product set and switching. But there’s real synergy there between kind of the data that US collects and monitors and the Awake sensors and being able to kind of marry the two of those as part of the switch and then sell that as part of the switch solution, right. So we took our first, very first step and it’s the first step towards kind of integrating those two. But when you think about security, that’s how we think about security and saying, okay, we have a unique perspective on the network. We have a unique access to data on the network. How do you leverage that? And secure kind of what’s happening within the network as opposed to trying to do things that are kind of out our domain expertise, when we have kind of this tam that we can go and address, and so we’ll stay focus on doing things that are, the focus around the network itself.
Meta Marshall
I think I’ll give you a break from the technical questions for a second. And dive into financials. Obviously, Arista has had phenomenal operating margins over the years, but just in terms of your guidance this year of operating margins of 38%, or just investments you would like to make just how do you see, areas in which, you want to invest for growth over the next couple of years?
Ita Brennan
Yes, I mean, I think, look, on the sales side, we’ve kind of fallen nicely into this motion of adding roughly 30% plus or minus to the sales team. And we feel like there’s a good absorption of that, and a good kind of return on the cash, right. On the software side, and the R&D side, I mean, it’s all about people and talents. And we would go as fast there as we can, right? That was — we didn’t do as well there as we would have liked last year, just because it was a difficult year for hiring, et cetera. We’d hoped to do better this year. And that’s just because there’s so much work that you could do that’s tied to revenue, that you definitely want to acquire those resources as fast as you can, right. You can, we grow that at the same rate as the top line? We’ll see. But the definitely intent, and that will be the right thing to do if we could do it, right. I think the other factor this year, we’ve talked about gross margin a little bit, but I think gross margins will be pressured a little bit, and that’ll obviously impact the operating margin as well, right. And so we’ll see where we come out. But I think, we do have a serious intent to go kind of drive hiring on those two areas.
Meta Marshall
Got it. I mean, one element of that gross margin is just maybe some of your larger customers purchasing, but the other, now we can turn to everybody’s favorite topic of supply chain. And clearly this has been an area of disruption that you guys have managed better than a lot. But just what are you seeing just in terms of, and what are you seeing in terms of, is it stabilizing and getting better? Just any update there?
Ita Brennan
Yes, I mean, I think it’s hard, probably it’s hard to kind of baseline things like this, right? I think what we said on the call as well we don’t feel like it got necessarily much better or worse, right? I think it was reasonably stable, you still have, and you are still in an environment where you have surprises, right? Happening, and for us to kind of really get some momentum behind truly driving higher volumes and shortening lead times, et cetera, et cetera, we’re going to have to those surprises are going to happen, the number of surprises has to come down, right, you have to start to really feel like you’re getting your arms around more and more of the components. We’ve been broadening out our focus, direct focus, if you’d like, use to manage key components, now we’re managing a broader set of components, still through the CMS book kind of forming, contact directly with the end customer, we’ve obviously made some expanded purchase commitments to just to help secure kind of your position in line that helps for sure. But I think we’re not yet at the point where you start to say, you’re really seeing some significant improvements and the level of surprises is coming down, et cetera. I think we now think that’s probably a 2023 dynamic, best as we can see now.
Meta Marshall
Got it. I mean, you just alluded to kind of inventory build, that you’ve kind of put into place, having meaningfully kind of more inventory than you have. Can you just give us a sense of, was that all just a genius foresight, just to kind of what were the signals? And what is the biggest kind of component of some of that inventory?
Ita Brennan
Yes. So when you think about the purchase commitments, it’s not that I have the inventory today, and I kind of wish I had, but we don’t, right. So it’s really, it’s more kind of taking your, you’re putting out your kind of commitments for the future in the hope that by being kind of in the chain, you’ll have better access to inventory, still won’t be perfect, right? That’s – you still can have surprises, but at least you’ve got your consecutive kind of positions in line, and that hopefully will help with the supply, right? I mean, the inventory itself, it’s up a little bit, we did kind of double down on some of the key components early on. And you saw a little bit of growth in the raw materials and stuff because of that, but a lot of this is really more making kind of confirmed commitments to the future periods. So that hopefully you get that inventory when you get there. And again, the expectation is that still won’t be perfect, right? But it helps, right it’s kind of to maybe be in a better position as to supply should help with expedite fees and other things, hopefully. And the cost of it at this stage and because we’re early in product lifecycle is really tying up cash, right? Well, ultimately we’ll end up kind of having to add some cash to cover some of those commitments, right. But so that seems like a good trade off to us versus, being, 12 plus months away from any being able to have any upside, right. If you don’t have those commitments in place.
Meta Marshall
Got it. I might be added here versus the end of just any Ukraine, Russia impacts since it’s kind of tightening various things around the world.
Ita Brennan
Yes. I mean, there’s nothing significant directly for us, right, we don’t have a huge exposure there. Are there second and third order effects to the supply chain? And so I think that’s still something that’ll have to work its way through the system. So I think there’s nothing specific that we know of today. But it is one more shock to the system that didn’t really need any more shocks right now. I think so we’ll have to see how, if there is anything else that comes out of it.
Meta Marshall
Got it. Clearly investors can see where the source of the 30% growth comes from this year with just a lot of product upgrades or upgrade cycles kicking off, but just what gives you confidence in kind of the longer term, double digit revenue targets that you laid out at the Investor Day?
Ita Brennan
Yes, I mean, we talked a little bit about, the different building blocks, right. And I think you’ve got the enterprise business, which really is kind of a new logo share gain story, right. I think we have some good momentum there. So we need to continue to execute against that. So we think that business is a, it’s been growing roughly 30% CAGR for the last five years that we can continue to execute there. There’s lots to do in front of us right around that business. I think clouds, we’ve established that we can kind of go through repeated cycles and get our fair share of that business. What their spend will do is something that’s kind of a little harder to predict if it will be, a straight line up into the right or will it have some cyclicality to it, right. I think with that’s something that will evolve over time, right now, they seem to have an urgent need to deploy equipment. And that will, with the supply constraints, everything else that will last for a while, right. And then, is there some volatility to it after that we’ll see. But I think we get to a world where when cloud is strong, you’re going to grow very helpfully, the rest of the business hopefully supports growth, and a period where cloud is maybe more muted. And you kind of have that model over time, which is kind of you have a good steady CAGR double digit CAGR growth over time.
Meta Marshall
Got it. I want to open it up to questions if there’s any from the audience. All right. I have more questions. And so if we turn to the future, clearly EOS and the modularity of it, and the ease of use of it has been kind of the differentiator for Arista for the last kind of 10 years. Just when you’re seeing either your cloud customers push you for new features or enterprise push for new features, what are those that’ll be the next generation of differentiators? Is it AI? Is it kind of increased security tie-ins? Just how do you see differentiation developing?
Ita Brennan
I think it all those build off of EOS, right. And whether it’s kind of pushing the boundaries on, Ethernet and AI, and being able to do more and more, I mean that comes from kind of just pushing the envelope on the development of those high capacity systems over time, right, that’s leveraging EOS plus silicon plus other things. So we’ll continue to do that. I mean that’s kind of bread and butter to be, a good supplier to kind of the larger cloud customers, et cetera, that you’re continuing to do that. I think on the enterprise side, there’s more to do around just helping them manage the network, making that simpler, easier, more reliable, across kind of their deployments, right. So more with Cloud Vision more monitoring, we’ve talked about more security of the network with leveraging Awake, there’s a lot to do there still, and that will get pulled in conjunction with customers over time , right. But yes, I think it’s, we have an important role that we can play and kind of just helping kind of make that infrastructure more robust and easier to manage for enterprise customers, which is what they want, right? I mean, they really want to be more efficient service providers to their businesses. And just more robust and it’s becoming more and more important to companies to be able to do that. So I think there’s a lot we could do there with the tie-in of Awake, some of the other visibility capabilities that we’ve been adding.
Meta Marshall
Got it. Another area where you guys have alluded to is potential entry into other kind of web scale customers. And just what is that evaluation process, or entry or opportunity set for you guys that you see with kind of some of the other web scale guys they don’t do major business with today? I understand you do business with everybody but.
Ita Brennan
Yes, I think the concept that Anshul has developed over time of making buy is very interesting in this context, right? And can you, can a customer be better served, if you’d like with that combination, right? What does a branded supplier like Arista bring to the table? And then in conjunction to having multiple sources of supply, which is what they’re obviously trying to achieve, right? And that model has worked very well. I think there’s some openness to that with other customers. The problem is, it’s really hard to get to you, right? So again, it stops, I think about this as something that’s absolutely worth kind of exploring and engaging in but it’s not a simple thing to do. And it will take time, even if you were to be successful. So I think it’s something that’s, I think, for us to worry about for now as opposed to anybody else. And if we were ever able to make progress, I think we could, we would talk about it some more, but it’s intriguing. It’s just really, really hard to do.
Q – Meta Marshall
Got it. Perfect. Well, Ita, thank you so much for being here today and appreciate seeing everybody in person again.
Ita Brennan
Yes, thanks for having us.
