Service Provider Cloud

Arista Falls & Suggests Facebook Dropped the Banana Peel

Arista's stock is getting a bruising as it warned of "sudden softening in Q4 with a specific cloud titan customer." And, while the company didn't name which customer gets the blame, it's fair to say that company CEO Jayshree Ullal gave Facebook the side-eye on an earnings call with analysts Thursday. And analysts are saying after the call that, yup, Facebook's the problem.

Microsoft and Facebook will comprise greater than 10% of revenue in calendar 2019, Arista CEO Jayshree Ullal said on an earnings call with analysts Thursday. Hypercloud providers are Arista's biggest customer segment. Arista calls them "cloud titans." The "modern enterprise" is second, with financials in third and service provider and tier 2 specialty cloud providers coming in fourth and fifth, Ullal said.

Arista's stock traded down 25% Friday afternoon to $183.92.

The problem with cloud titans started smaller. Arista "experience[d] the pause of a specific cloud titan's orders in Q2 2019," but expected a recovery in the second half of 2019 for cloud titan spending. Q3 showed "good evidence of that," Ullal said.

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"However, we were recently informed of a shift in procurement strategy with a material reduction in demand from a second cloud titan, reducing their forecasts dramatically from original projections for both Q4 2019 and for calendar 2020," she said.

"Naturally, this type of volatility brings a sudden and severe impact to our Q4 guidance. Given this tepid forecast and volatility of this cloud segment, we believe the cloud titan forecast should be modeled as flat to down in calendar 2020," Ullal added.

The affected cloud provider is shifting from long-range buying to just-in-time spending, which is hitting Arista's revenue, the Arista boss said.

"This particular cloud titan has not only given us a dramatic reduction for Q4 2019 but has given us a dramatic reduction for much of 2020," Ullal said later in the call. Unless other cloud titans increase spending, "we fully expect this particular cloud titan to reduce next year significantly."

Evidence points to Facebook being the culprit here. Historically, Microsoft is the one big customer providing more than 10% of Arista's revenue. Arista "fully expect[s][Microsoft] to be north of 10% customer concentration for 2019. And we expect to have a second new cloud titan customer which will be Facebook," Ullal said Thursday.

As regards Microsoft, Arista COO Anshul Sadana said they expect "nothing different... on a usual spending pattern" from that company. Ullal agreed. "No blip, no pause, not yet," she said.

That suggests Facebook is the company tapping the brakes on spending. Wall Street analysts at MKM Partners reported that as fact: "ANET management says FB's orders suddenly slowed at the end of 3Q19, accompanied by a large 4Q19 and 2020 forecast reduction," the analysts said in a note. "Arista believes FB's demand for new Switches and Routers is pushed out by a year because it is delaying its Server refresh by a year. The delay in upgrading Servers is having a knock-on delay on the related Networking equipment upgrade. FB is also switching to a just-in-time procurement system, but this is likely not a reason for Arista's lower 4Q19 sales forecast."

Arista's guidance for the fourth quarter are revenues of about $540 million to $560 million. MKM says that's a "shockingly big reduction primarily due to FB, but also includes weaker performance in the Service Provider and Tier 2 Cloud Provider verticals. Arista does not think it is losing share at any of its Cloud Titan accounts, although we believe Juniper... has secured a couple of key 400G Switching and Routing design wins that could translate into share gains in 2H20 or 1H21." Prior consensus for Arista revenues was $686 million, MKM says.

2020 revenues are "implied to be flat to down," MKM says.

But Arista does not see the issue with the one big cloud provider spreading to the sector; it's one company changing its internal business process, Sadana said. Still, spending from other cloud titans will be, on average, "flat to down," Ullal said.

Other than that, how was the play, Mrs. Lincoln?
For the third quarter overall, Arista reported revenue of $654.4 million, up 16.2% annually. Non-GAAP net income was $217.1 million, or $2.69 per diluted share, compared to non-GAAP net income of $171.3 million, or $2.11 per diluted share in the year-ago quarter.

Arista makes massively powerful networking equipment that powers the Internet's biggest data centers. That's been a mixed blessing for the vendor, which was founded by ex-Cisco executives. It's made Arista attractive to hypercloud providers, such as Facebook and Microsoft, and allowed Arista revenues to ride the wave of hypercloud growth.

But it also means that a lot of Arista's business relies on a few customers.

Arista has been working to diversify its business, expanding to the enterprise campus network and WAN and acquiring Mojo Networks, its first acquisition, last year. Mojo provided WiFi networking for enterprises, with a heavy dose of automation that Arista is integrating into its platforms. Campus business is "marching well to the $100 million in shipments for the first four quarters," with Q3 as the first quarter, Ullal said. But this week's results shows that Arista may need to step up its diversification plan.

Financial analysts at Jefferies are not optimistic, rating Arista's stock as a "hold." "While we still believe in the long-term growth of Cloud Spending, Arista clearly doesn't have the strength of the business to back-fill for a problematic customer like this. We remain on the side-lines with respect to the stock," Jefferies analysts said.

Why this matters
Hypercloud providers like Microsoft and Facebook are powerful influencers of the service provider industry. Consumer demand is driven by demand for Facebook – and YouTube, Netflix and other hypercloud services. And the enterprise side of the service provider business is driven by demand for public cloud services provided by Microsoft, Amazon Web Services, Salesforce and others.

Additionally, hypercloud providers have led the way in the transition to virtualized networking, a big priority for service providers.

If Arista is right that the glitch in its earnings is due to a relatively insignificant change in one company's business processes, then that won't matter much to service providers.

If, however, Arista's problem is a sign that the hypercloud business is slowing, that would be very bad news for service providers indeed.

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