We often receive specific questions from members for research requests on stocks not within our coverage universe and specific questions regarding companies already within our coverage universe. Let’s take a look at one of each such situation in this article.
By Kris Rosemann
Arista Networks (ANET) – Scalable Business But Not Without Challenges
Arista Networks is a leading supplier of cloud networking solutions that utilize software to address demand from large-scale Internet companies, cloud service providers, and next-generation data centers. According to third-party estimates, the company has the second-largest market share in datacenter 10/25/40/50/100 Gigabit Ethernet switch ports as of 2017.
Arista Networks operates in the large and growing cloud networking space, and it is working to take advantage of the migration of enterprise workloads to public and hybrid cloud solutions. It continues to set its sights on taking share in the high-speed data center switching market, and it lists the following characteristics among the advantages of its cloud networking portfolio: scalability to millions of users, enhanced resiliency, 10x-40x more cost effective, open programming, programmatic API usage, and automated management. Its mission is to provide the best solutions for private, public, and hybrid deployments.
Arista typically targets its gross margin in a range of 63%-65%, but management expects near-term results to be capped at the midpoint of that range due to the impact of tariffs. It expects supply chain modifications to take effect over the course of 2019 in response to the cost pressures, but execution risk is then introduced. Free cash flow exploded higher in 2017 to ~$616 million from $152 million in 2016, but it has since come back down to earth through three quarters in 2018. We’re expecting the company’s free cash flow margin to take a step back relative to 2017 levels but remain strong and move higher over time as the business scales.
As of the third quarter of 2018, Arista generated ~72% of its revenue in the Americas, and Microsoft, via Arista’s channel partner World Wide Technology, accounted for 16% of 2017 revenue, indicating a degree of customer concentration risk that may only intensify if the swaying power of large-scale Internet companies continues to concentrate. Nevertheless, we like the company’s balance sheet health as it held ~$1.7 billion in cash, cash equivalents and marketable securities at the end of the third quarter of 2018 compared to $36 million in long-term lease financing obligations, and such flexibility bodes well for a company looking to compete in a dynamic and rapidly growing market with intensifying competition that demand innovation.
Arista Networks does not pay a dividend, and shares are currently trading at just over 25x consensus expectations for 2019 earnings. We see shares as fairly valued based on our discounted cash flow-derived fair value estimate of $233. We think the company currently deserves its somewhat lofty PE ratio due to its high-growth potential and our expectations for free cash flow generation (and free cash flow margin) to remain strong as the company takes advantage of the scalability of its business.
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The following question has been edited to better suit this format.
Dear Valuentum Team,
I recently read that Holly Energy’s (HEP) sponsor, Holly Frontier Corp (HFC), has exhausted all of its dropdowns to Holly Energy. I was hoping to receive a comment regarding the potential consequences of this, in addition to your opinion of Holly Energy’s access to debt and equity markets moving forward in light of its current debt load and share price.
You are correct in your concern over Holly Energy’s reduced access to new growth opportunities via dropdowns from its general partner, Holly Frontier. The general partner has no more midstream assets to drop down to Holly Energy. The MLP may not consider acquisitive growth and more aggressive capital spending to facilitate expansion necessary to continue paying its growing distribution. It is important to note that Holly Energy’s unadjusted Dividend Cushion ratio is in negative territory, highlighting that it has been relying on external capital financing to grow the business and distribution. The entity may continue to have to do so.
The dependence on capital markets for growth is likely to increase moving forward as Holly Energy will be forced to build and/or acquire new assets and businesses. It plans to partner with Holly Frontier in this initiative, and the recent elimination of its incentive distribution rights (IDRs) should help simplify its business. However, complicating matters further is Holly Energy’s junk-territory credit rating (Ba3 from Moody’s), which could come back to haunt the MLP should credit markets tighten in a material way. Tightening distribution coverage ratios (using industry-specific measures of cash flow) more recently highlight the concerns surrounding potentially less attractive growth opportunities as a result of the lack of dropdowns from the general partner.
All things considered, we’re not fans of Holly Energy’s long-term distribution profile. That is not to say that we feel a cut is imminent, but its payout is what we refer to as “financially-engineered.” The MLP’s need to fund growth via capital markets at potentially less favorable terms than it had been privy to in the past could exacerbate the impact of this issue, especially if favorable growth projects are not readily available amid a consolidating North American midstream space. Units of Holly Energy are currently trading roughly in line with our fair value estimate of $31 per unit, and its unadjusted Dividend Cushion ratio is firmly in negative territory.
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Kris Rosemann does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.