Arista Networks, Inc. (NYSE:ANET) Citi’s 2023 Global Technology Conference September 7, 2023 1:00 PM ET
Company Participants
Ita Brennan – CFO
Conference Call Participants
Atif Malik – Citi
Atif Malik
Good afternoon everyone. Welcome to day-two of Citi Global Technology Conference. My name is Atif Malik. I cover U.S. semiconductors, semiconductor equipment and communication equipment starts here at Citi. It’s my pleasure to welcome Ita Brennan, CFO Arista Networks. We also have Liz Stine, Director of IR in the audience. Welcome Ita.
Ita Brennan
Thank you so much. Thanks for having us.
Atif Malik
I’m going to start with my questions first and then I’ll take a break and ask you guys if you have any questions and if you have a question please raise your hand and we’ll get the mic to you. Ita we were talking about the A word before the fireside chat, so I’m just going to get straight to that. What is the AI opportunity for Arista and how meaningful of a revenue contributor is it today versus two to three years ago from now?
Ita Brennan
Yes, I think, look, there’s been some industry analysts who’ve tried to size this market in terms of just the Ethernet switching piece. You know, you’ve had kind of a $2 billion to $3 billion number being tossed around. But in reality, I don’t think anybody has a proper sizing of the market yet and that’s just going to take some time. Certainly in terms of the products that we sell and the products that we will sell, it’s not going to be completely obvious what use cases they are being deployed in. So again, we’ll have to track that somewhat off system to get some kind of sizing on that market. But today we’re selling those products into various different use cases.
I think what’s interesting for us around AI is, obviously we’ve been selling products into kind of the front end of AI networks probably for some time without even knowing that right, where we were transporting data from some of their back end processes out across their networks. I think the more exciting thing now obviously is talking about what does the back end of these networks look like and what kind of opportunity can that drive. That’s right now we’re in the throes of kind of that’s driving lots of technology development urgency around some technologies that were in the pipe anyway, around moving 800 gig speed, some software features et cetera.
So I think more than having a clear discrete view of exactly what it’s going to mean in the near-term it’s more exciting about the fact that it’s driving urgency around the technology and it’s allowing us to continue to develop new features and work with customers to develop new features and expand that relevance over time. So I think today it’s — we probably have some AI dollars on the front end of the processes. I think we’re in the very beginnings of trials, pilots, et cetera around some of the back end processing and that’s going to continue as we go through kind of next year and beyond. But it makes — it’s a very interesting time for the engineering teams, the software teams, et cetera to be able to engage with customers around some of these problems and some of these and find solutions.
Atif Malik
Great. Let’s talk about the cloud CapEx. What is Arista’s visibility with regards to cloud titans investments in classic cloud computing?
Ita Brennan
Yes, it’s been, you know, it’s been interesting, right? We’re just coming off of this most bizarre supply period that we had, right? We’re still working hard to fulfill some deployment schedules that we agreed with those customers some time back, right? So we’re continuing to execute against that and we’re improving lead times. Hopefully by the end of the year we’ll be back to like a six-month plus or minus lead time. So we’re kind of getting in range now where we’re starting to see customers start to figure out kind of what is the next level of demand what those new lead times look like.
We still have work to do or around that. But you can see that they’re continuing to invest both in the kind of traditional classic networks and also supporting some of that front end AI and then obviously lots of discussion around kind of what other use cases can there be around AI into the future. So I think we’ll end up back, it used to be a churns business in a quarter in the old days, pretty supply chain, hopefully we’ll end up something a little bit longer than that, especially given some of the lead times on some of the key components. So somewhere around six months is probably where we’ll end up.
Atif Malik
Great. You know when I looked at the workloads in the cloud, the majority of them are still like analytical based and it’s not AI everywhere. And so at some point the demand has to kind of come back for the general purpose, the servers and for you guys the 400G side, are you seeing any kind of green shoots that the focus is shifting away from 800G to 400G or is it still quite early?
Ita Brennan
You mean from 400G to 800?
Atif Malik
Yeah, yeah.
Ita Brennan
Yes, I think it’s a little bit early, right? Because you’re just not, you’re not quite there yet. It takes time and we have silicon now for those products, but it’s still going to take some time to actually ramp the systems themselves, the software, get them qualified et cetera. So I think 400 gig is going to drive kind of revenues for certainly through the next period of time here, right, which is normal, right? I mean normally you see silicon it will take somewhere like a year plus to get to a system a fully qualified kind of revenue shipment from there. So it’s — yes it’s not unusual I think 400 gig is going to be the speed of choice here for a while and then even when we go to 800 gig, you’ll see a whole refresh of kind of 400 gig, 100 gig platforms leveraging these silicon as well, right.
Atif Malik
Okay. And then on the enterprise side, you guys saw strength in the last reported quarter meetings talk about campus switching routing, how meaningful does campus switching and routing portfolios from a revenue and margins perspective?.
Ita Brennan
So routing is hard to break out. I mean a lot of our routing work was initially done for the cloud and for the hyperscale customers and we essentially rebuilt the routing software stack for those customers and we’ve definitely earned a more prominent position in some of their LAN networks as a result, right? So we have products that are shipping into those customers, some being used inside the data center, some being used for routing because that’s the beauty of the overall solution, right. It’s the same box.
On the campus side we’ve talked about we were shooting for a $400 million number last year. We were shy of that a little bit just because of the supply, but the demand is there. We have a target of $750 million for 2025 and we’re on track for that number. So it’s becoming a more significant piece of the business. And not only is it driving dollars kind of for the campus piece of the business, but it’s also opening up sometimes some opportunities to sell into the data center. Again, it’s another avenue of entering an account, entering a large enterprise account is to actually engage on the campus side and then when that and then we can kind of work our way back to the data center. In some cases obviously it works the other way as well just depending on the customer.
Atif Malik
Okay. And Ita, when I talked to Jayshree, she sounds very excited about incremental share gains and the enterprise side from the incumbent and we saw through earnings results like Juniper, Cisco, you all guys had good upside on the enterprise side. So help us understand how much of the strength you’re seeing of share gains versus from the organic market?
Ita Brennan
Yes, I think particularly in campus like the overall market itself I think over a period of time hasn’t been growing that aggressively. We saw a little bit of growth recently, but it’s still not an aggressive grower. So it’s really more about kind of where we’re taking share in that market, right. And we’re targeting you know customers, high tech customers who are looking for the benefits that we can bring with the OS, with CloudVision all the way through kind of their, in some cases data center network through to the edge or in their campus networks.
So I think a lot of what we’re seeing is really share gains. I mean we’re still very small in what’s a very large market and there’s a real opportunity to be a new supplier to that large enterprise piece of that campus market and that’s kind of where our focus is. So I think the excitement I think that that we see is, we are seeing good, we’re being pulled into opportunities by those customers, by those large enterprise customers and we’re becoming more known kind of in that part of the market and it’s more diverse, it’s across lots of mini, what we call mini verticals inside that enterprise. But we’re seeing customers in manufacturing world or the, you know Jayshree has tried to give some color just the types of customers that we’re winning now and it’s way broader than what we used to do prior and I think that’s part of the excitement as well is that we’re actually now have like credible solutions and references for different verticals within kind of that campus footprint as well, right.
Atif Malik
Great. And then putting it all together and Jayshree gave us a little bit of a teaser on the earnings call on the double digit growth next year, and I don’t want to front run your Investor Day in November, but how should we think about the bridge from the cloud this year into next year as well as the enterprise demand perhaps sustaining? Maybe you can walk us through some pointers.
Ita Brennan
Yes, I mean I’d still go back to the thesis we’ve been sharing for a while now which is after two outsized growth cloud years, we do expect cloud to be muted next year. AI is helpful in terms of the long-term picture, but we’re not sure that it changes that dynamic. So I think we’ve we put out some guidance at the last Analyst Day that had us growing single digits and that 2024 kind of when you back solved the CAGR. Jayshree has had a desire and a goal that she’s been driving the organization to say could we at least get to 10%. And I think you know we’re becoming more comfortable with that over time, hence the teaser.
I wouldn’t get too far ahead of us beyond that because I think it does assume that cloud is muted and that we are relying on kind of the enterprise and consistent execution and enterprise et cetera, which that’s certainly one way to get there. And we’ll talk a little bit more at the Analyst Day about maybe some other drivers there that can kind of, I like to have the multiple building blocks. We’ll talk about that some more. But I think it is kind of a lower double digit number assuming that cloud is muted and then we’ll see where we go from there.
Atif Malik
Great. I’m stuck with the margins and how does customer mix versus target mix rank in terms of driving margin expansion?
Ita Brennan
I mean customer mix is still by far the biggest driver. I mean, we have some tidy up to still do on supply chain. We have a big focus internally and kind of putting supply chain back in the box just in terms of cleaning up purchase commitments, getting some of the inventory metrics back to normal and then earning back kind of some of the cost increases et cetera that we bore because we expect customers to come and ask for that back on the front end as well over time. So that’s kind of work that’s in progress, that’s been helping us kind of improve margins as we’ve gone through the year and I think we can continue to do that through the end of the year and then it probably stabilizes from there. And then we’ll be back to really the biggest driver being customer mix and where obviously cloud when it’s heavy cloud it will have a lower gross margin, but then still significant flow through to the operating line and obviously when enterprises is stronger we’ve got higher gross margin. But then we will continue to kind of add sales and marketing investments as we go to support that business.
Atif Malik
And are 400 gig switches higher margin than 100 gig?
Ita Brennan
I mean it mostly nets out right? If you go back and plot kind of our gross margin over time, it tends to net out and some of that’s intentional. I mean obviously we’re negotiating all the time based on the underlying cost structure. So best as you can you’re always trying to match kind of some of the cost pressures that you’re getting with some of the price reductions that you’re having to give and we manage that across the products. So new products tend to have, initially have a higher cost and then kind of work their way down, but we try to manage those in tandem. So we haven’t seen that much of a change in gross margin across the different product cycles.
Atif Malik
And the margins, you’ve had tailwinds this year from the COVID disruption as things are starting to normalize in supply chain. Will that remain a tailwind through the end of this year and how much more headroom there is for margin expansion from supply chain normalization?
Ita Brennan
Yes, I think we’ve talked about gross margin kind of stabilizing at the end of the year with maybe — there’s probably hopefully another bit of improvements kind of through the end of the year, we’ve kind of been stepping kind of improving as we’ve gone through Q3 and then I think it probably stabilized and then it will come back to more just being about customer mix and what the customer mix looks like.
Atif Malik
All right. This is a question on investors mind in terms of the CFO transition as you’re going to be stepping away. Is Arista pursuing an internal or an external search and what is the targeted timing of the transition?
Ita Brennan
Yes, I mean we obviously talked about it early right to give us and to give everybody else a chance to kind of absorb it and give us some time to look for the right person. So we’re engaged in that now. I’m committed to being part of that process and helping with the transition. And so however long it takes for us to get to a good partner for the team going forward, that’s what we’ll do, right? But it’s sometime next year for sure. It will just depend on when we kind of find the person that everybody is comfortable with.
Atif Malik
And then the OpEx side, how do you guys kind of allocate the R&D priorities across multiple areas in enterprise and energy and AI?
Ita Brennan
Yes, I mean a lot of the core kind of software work is leveraged across all of it, right. When you think about EOS and just moving as we go through the speeds and we add features like routing and other capabilities, that’s shared kind of across — that’s part of the model, that’s why the model works so well, right. Those investments they are initially driven by cloud, but then they’re shared across kind of other clouds, service provider and through the enterprise as well, right. There are certain things that we do that are for the enterprise business, right. And we’ve been working hard to become a little bit more disciplined by carving those out and Jayshree has a big focus there in terms of making sure we’re doing enough. That’s CloudVision, some of the visibility tools, automation, some of the campus only kind of features that we want to fill in, but that’s still a relatively small part of the overall lift just in terms of where the resources are going. So there’s good commonality across the different parts of the business for a lot of the R&D.
Atif Malik
And it will be helpful to know where we are in the 400 gig upgrade cycle, are we like 20% through or 30% or?
Ita Brennan
Yes, it’s been harder to kind of, we used to think of it as like well 40 gig then 40 gig goes away and you get 100 and then 100 goes away and you get — and then with this last set of products what you’ve really seen is 100 is continuing to be deployed broadly, right. You’ve got 200 gig in certain cases for certain customers than you have 400 gig. So I think even after we have an 800 gig offering and it’s been deployed in certain cases, you’re still going to have some customers will be deploying 400 gig and 200 gig, right? So it’s been — those high speeds are becoming — the silicon is changing underneath and you’re getting a whole new set of more efficient products, but customers are still deploying different configurations depending on the use cases. So I think we’re obviously well into the 400 gig deployment, but if you think about the business, say last year, this year I mean we’re still deploying a lot of 100 gig too kind of in that time frame, new 100 gig, more efficient power efficient, et cetera, but new 100 gig. So I think we’ll see — we’re obviously getting a lot of dollars from 400 gig right now and we’ll continue to and probably continue to even after 800 gig shows up, yeah.
Atif Malik
Okay. Ita, when talk to Cisco, I mean they acknowledge that the guys, I mean those guys from last 400 gig to you guys and on 800 gig there seems like they’re putting a bigger focus. So how should we think about competitive dynamics going into 800 gig?
Ita Brennan
Yes, I mean I think we’ve gone through multiple cycles now where it’s 100 gig, 400 gig was supposed to be a cycle where there was a lot of noise around competitive products. We’d expect the same again at 800 gigs. I’m not at all surprised. If I was in their shoes I’d be putting wood behind 800 gig as well. But again it all comes back to, we have to execute well. We need to — if we deliver the right products, if we work with these teams and these customers, we can earn our fair share of that business and we’ll let the competition take care of ourselves. But we’ve been, the team has been doing a really nice job of executing well against products with these customers.
We saw it at 100 gig, we saw it at 400 gig. Again there’s a huge focus on 800 gig now inside the team. So I mean, I wouldn’t bet against them continuing to drive that execution because it really is all about execution for these customers, right? Give them a product that’s reliable, has a software stack that you can ramp straight away, that’s what wins you that business, right? So we need to stay focused on that and I mean I would expect them to compete hard for that, but I think the team is good at this and we just need to deliver.
Atif Malik
Good. You know, I mean we were just coming back from the NVIDIA fireside session and they had this chart with InfiniBand is growing like 4x and so obviously they’re seeing the success on InfiniBand on the first wave of 800 gig. And the big debate is like what will be kind of the mid to long term mix of this market and when we talk to fabless companies like Marvell and Spear, it sounds like the Ethernet is just starting to get adopted as well and or being evaluated right now into next year. So, we’d love to know your thoughts or if you’re seeing any kind of green shoots for Ethernet adoption for 800G?
Ita Brennan
Yes, I think at the end of the day what’s going to matter is kind of what gives you the best AI enabled network, large network. I mean that’s what we’re solving for right, is being able to have these large multi-tenanted large footprints with from a customers’ perspective with multi-vendor, multi-providers and lots of contributors to that architecture and that network. I mean, that in our minds is what’s going to win and standards based right. And that is — that’s our Ethernet strength at the end of the day, right.
If you look at the history of how Ethernet has evolved over time, right, it is a standards based broadly deployed architecture and we believe it can solve any problems that need to be addressed around AI. There’s some work to do there, but we’re continuing to do that and it will continue to evolve. But customers are going to look for that environment, right? That’s what allows them to scale to the levels that they’re going to want to scale this to if AI is everything that we believe it’s going to be, right.
So I think we’re betting on Ethernet because we’ve seen multiple different architectures kind of try to compete against Ethernet. But in that environment where you want to have this kind of large standards based open architecture, Ethernet tends to win. Now again, we have work to do, we need to do it, but I think from a customer perspective that’s a solution that they’re using today. It’s deployed pervasively today. They have the expertise there. So that — we believe that’s where it’s going to end up. It won’t be 100%, but there will be those large scale footprints will we think we’ll end up deploying Ethernet. But again there’s work to do, we need to, we need to just execute and do it. But customers are definitely interested in making that work.
Atif Malik
And then the threat of a white box makers in terms of the competitive landscape and that question never kind of goes away. When we look at the Delaware data, it seems like that share has kind of stabilized for white box makers. Can you just talk about what you see in the market for white box makers?
Ita Brennan
I mean, I don’t know that there’s been any fundamental shift in white box for a while now, really, right? I mean, it’s that you have kind of the two large players that do their own and then you have kind of the dual co-development arrangements that have been in place. But it’s been pretty balanced, right? And the more complexity that there is, the more change that there is that doesn’t tend towards I think more white box, right. If anything it probably balances it out and maintains the status quo. So I don’t know that we’ve seen any shift kind of towards white box for a while now, but that question never goes away, right. We’ve been answering that since I joined Arista. I think that was one of the first questions, big concerns everybody had back then. So yes, I don’t think it’s changing now.
Atif Malik
And what has to change for you to change your shared position at kind of the large cloud titan that I think investors expect at some point you’ll have a shot at, is it something on their side or something on your side that you have to kind of technology wise get to meet their requirements?
Ita Brennan
I mean, I think on the technology side there’s good alignment from a technology perspective and Anshul has commented on that before. It really is, it’s a huge decision for an organization to make. So it’s really in their hands to decide kind of what makes sense for them. I mean, we’ll continue to collaborate, share technology, et cetera and it really is in their hands. But again from my perspective, I’ve said this many times, it’s not something that should be in the near-term because we can’t control it, right. So again, we’ll continue to build those relationships and share technology and we’ll see where we end up.
Atif Malik
Great. Let me pause here and see if any questions in the audience.
Question-and-Answer Session
Q – Unidentified Analyst
I was hoping we could go back and talk about margins a little bit. In the most recent 10-Q filing, there was a note that one of the contributors to the decline in margin was provisions for excess inventory or inventory obsolescence. So just hoping you could talk about that a little bit?
Ita Brennan
Yes, I mean obviously our inventory has been growing and particularly kind of on the raw material side of things, the inventory levels have been growing. We always have a certain level of reserves that we carry to cover that inventory. As that inventory has been growing, we’ve been increasing those as well. I think it behooves us to make sure that we have kind of a consistent level of coverage on those inventory balances. When we came into this whole supply situation, we always knew it wasn’t completely risk free, right? But we thought it was a manageable risk. I think we still feel that way, right.
We’re working through the purchase commitments and inventory and making good progress there. But at the same time as that inventory balance grows we want to kind of, we want to continue to maintain some coverage on that not because of something is going to happen today, but obviously that it’s the tail of that inventory that you want to make sure you’ve got some adequate coverage for. So we are keeping an eye on that. But I think by the end of the day as relative to the inventory size, it won’t be that different to what we normally do. It’s just obviously as the inventory is growing, you’re seeing those increases go through the COGS numbers.
Unidentified Analyst
The following work in progress inventory now…?
Ita Brennan
I mean the finished goods are still, I mean if you look at it, our days of inventory on the finished goods size is still not nearly back to where it was pre. Yes, that’s I mean, it’s because most of the inventory growth has been in the raw materials and that’s kind of where we’re addressing that too, right. Just because we’re really kind of just working on the basis of the inventory balances are growing, right that we should kind of cover that off.
Unidentified Analyst
Thank you. Maybe if you can maybe double click on the kind of challenges Ethernet has to solve now to gain more share on InfiniBand? And maybe kind of from the get go what InfiniBand has that Ethernet didn’t? What are the different obstacles that Ethernet has already surpassed to kind of gain more share on InfiniBand just double clicking on the challenges Ethernet already surpassed and what’s remaining?
Ita Brennan
Okay, I’m going to try, but remember I’m the CFO, so it may not be very satisfying. Yes, I think, look, historically InfiniBand probably had higher speeds, right? Ethernet was kind of was needed to catch up on speeds. I think we’re pretty much catching up on speeds now, right? And then the other piece was just kind of the management of the traffic flows right? This whole rocky discussion right, where Ethernet now also has basically learning from InfiniBand overtime now has some of that — has the ability to kind of manage those flows as well in Ethernet. So a lot of those things have been, so a good number of those things have been solved. And I think Jayshree put it well on the conference call which is like neither Ethernet nor InfiniBand today is perfect for AI because that’s a whole new kind of use case and challenge.
So I think both technologies will need to evolve and will want to evolve right and a lot of it is around. You’re just managing traffic making sure that you get to that lossless or Anshul likes to say almost lossless, but really lossless delivery because that’s what you need for AI, right. So there’s some more software management, management of those flows that you can do to make sure that that you solve for that. So that’s an area for sure that we’ll continue to work on between buffers and then making sure that you have that predictability and that you deliver every package gets delivered is a focus for Ethernet.
On the InfiniBand side, I know there are other things that need to be solved there too, but a lot of it is to just to do with the fact that it doesn’t scale to these multi-tenanted and that it’s not open and that it’s not kind of you don’t have that same standards based supply base that you do on the Ethernet side.
Atif Malik
Questions? Ita, are there other adjacent markets that Arista is considering entering? And also if you can talk about the software opportunity, because when I look at the three networkers, Juniper, Cisco, you guys, you all talk about software and other unique drivers to your software attach rates?
Ita Brennan
Yes. So I think we’re a little different in that. We haven’t tried to take the core operating system, EOS and bundle that separately, right. I mean for our kind of that larger enterprise customer base, that’s not something that they’re interested in doing. It doesn’t resonate well with them. So it behooves us to get paid in terms of the actual pricing on the port and the hardware, but we don’t have a separate software stream per se for that, right. But obviously we continue to do a ton of work there and that’s what earns us kind of the market share that we have, right. So then the other piece of the business is more around the subscription standalone products where customers really do have a choice and they get to buy those software products if they think they add value, right. And that’s CloudVision, that’s some of the visibility tools, it’s some of the AVA security tools, right. So those we sell separately and we sell it as a software subscription.
I mean in terms of your do we — what else do we do? I think we kind of balance all the time between, if we only did two things well, if we executed well in cloud and grew with that business and if we continue to execute in the enterprise and campus and take our fair share of that market like that drives a very healthy business in and of itself, right. So you need to say there’s an element of focus that you should have in executing against that and I think what you’re seeing us do is kind of fill in where we have gaps in that, in the campus offering in particular and where we we’ve been partnering or needed to partner and where it makes more sense for us to actually do something ourselves, whether that’s the WAN product that we announced, whether it’s kind of the AGNI, the NAC product that we announced, right.
So stuff like that where it really truly does make sense from a customer perspective for us to kind of solution that as opposed to introducing something else into the middle of that. That doesn’t mean we won’t partner and that there won’t be things we’ll partner with, there always will be right, but there are certain areas where it’s somewhat disruptive to the overall solution where we drop things in and that’s what you’ve been seeing us do over the last while and we’ll continue to do that.
Atif Malik
All right, great. We can wrap it up here if there are no questions. We still have a few minutes if you want to talk to Ita. But Ita, good luck in future and thank you for coming to Citi Conference.
Ita Brennan
Okay, thank you very much. Thank you for having us. Thank you.
