Tickers mentioned in this show: ANET

Tidal River Investments positions the day after the first show airing:

Long: NFLX, ETSY, SPY, TDOC, U, Z, ZG, WK, ATVI, AVGO, JPM, PRLB, ANET

Show Notes: Collected ANET data spreadsheet

2Q2021 Earnings Call transcript

Photography from Tidal River Investments can be purchased at tidalriverinvestments.com

Script

Welcome to Fluctuating Tides, the Podcast, Episode 11. I’m your host, SomeCodingGuy, and let’s get right to it!

This week I’m going to be covering Arista Networks, Inc., ticker ANET, a network gear provider specializing in high end, high speed equipment in the 100gig-e and above space that’s been growing quickly in all of their industry segments and well positioned for the growth of the internet.

For this week’s knowledge segment, I want to talk about inventory, especially as it pertains to Arista and the chip shortages, and how to keep an eye on it.

When a company builds products, they generally don’t start by making things from scratch. Think about your local diner - when you order an omelette, they don’t usually start your order by going out into the chicken coop and collecting eggs. Network equipment for Arista is much the same - they don’t start building microchips for high speed network gear by collecting sand from the beech to process down into high quality silicon wafers to make chips, either.

In public filings, one of the common financial statements that we look at is the balance sheet, which is a snapshot of what the company has and what it owes, otherwise known as assets and liabilities. We looked at this in last week’s episode to see payables and receivables, two things worth watching with manufacturers and other companies, but we skipped over inventories. I did mention it very quickly when we discussed Zillow about a month ago, but I wanted to take a closer look at it this week.

The inventories line shows the current value of whatever the company has in inventory, as of the last day of the filing period. This isn’t the same as cash that can be deployed, or buildings the company needs for workspace, instead these are either finished products, unfinished products, or sometimes raw materials themselves, depending on what the company does.

Why do we want to watch inventories? Well, the main fear- is when inventories pile up, and in particular, what sort of shelf life do they have. If we’re making pizza, inventories might be things like flour, cheese, and tomatoes (or maybe tomato sauce to save a little time), but as we all know, these ingredients don’t last forever, and if we pile up more of them before we sell enough pizzas, we’re going to be throwing them out. In accounting language, we call that a “write off” since we, quite literally, take the value of the bad goods being thrown out and “write them off the balance”.

Write offs don’t just come in the form of food spoilage - they could be a little more abstract, such as something that isn’t really worth what it used to be. Do you remember those old plastic sunglasses in the shape of 1999? They might not sell as well as they once did, so the company may decide it needs to write the inventory off the balance sheet, although who knows, maybe there’s a collector’s market for that kind of stuff?

Accounting has standards for just about every type of inventory out there, and usually somewhere in the company’s filing, you can find a note about which accounting standard they’re using, or which one they’re switching to, but aside from maybe a casual glance at why that’s happening, or the way it impacts the numbers, as investors, we probably aren’t going to review that too closely unless it throws our numbers way out of whack. What we are usually concerned with are how inventories are changing through time, and if there’s too much or too little inventory, and why is it there. Most companies will also usually break out the difference between raw materials and finished product, but that’s not usually shown on the balance sheet itself.

Now in the case of Arista, inventory has been piling up, and piling up much faster than sales. When I first started assembling the numbers in a spreadsheet, I made a note to go look a bit deeper into why that was.

Management was quite upfront about it, and came right out and said on the recent earnings call, “we’re piling up inventory” and the short version of “why” was: “shortages”.

This wasn’t the case of warehouses of 1999 plastic sunglasses - this was a company that had so much demand for its products from its customers that it literally couldn’t fill orders fast enough, between making the chips, to getting them packed into products, even to getting products shipped to the markets that were buying them. The chips, incidentally, were being made by Broadcom and Intel, and you might remember some of the discussion of the troubles Broadcom was going through with meeting their customers’ demand to fill orders vs. the increased cost of silicon wafers they bought for their own inventories.

High quality sand, apparently, is very costly these days. But as I heard recently on another podcast, “Silicon is just a rock that we tricked into thinking”, so maybe I should bring some silicon on the podcast to ask what’s going on in the chip industry.

Silicon aside, Arista is definitely selling a lot of product, between their network gear and their services, to the tune of nearly 3-quarters of a billion dollars in the most recent quarter, showing steady top line growth from 3-12% over the last year and a half, as all of their customer segments, or “verticals” as they call them, continue to increase demand for their high speed networking gear. The largest segment, what they call the Cloud Titans, dominated by Microsoft, Facebook, and Google from their most recent earnings call, makes up more than a third of their sales, but the other segments, including enterprise, financials, specialty, and service providers, have all been steadily increasing demand for their products. Arista is the market leader in software defined 100 gig-e network switches, and has been steadily investing in newer faster 200 gig and 400 gig switching fabrics. While the chip shortages may be short term, as Broadcom and others have cautioned, the internet itself and the connected world seem like a pretty good bet for the future, and the nearly $3b in cash and marketable securities leaves them plenty of runway to manuever if there are some bad times ahead. Arista isn’t cheap at a current price to earnings ratio of 44, but companies growing fast, even in manufacturing, rarely do show up on sale. I added more detail and observations in the spreadsheet included in the show notes, as well.

Given all this, Tidal River is going to take a position in Arista this week, and if the stock pulls back from its current levels, Tidal River will probably just pick up more shares of it.

If you like the podcast and want to see more content like this get created, feel free to subscribe on your favorite podcast app, or buy a photo from tidalriverinvestments.com - money earned on the photos gets deposited in the investment account. As always, Tidal River Investments and I are not financial advisors, market analysts, or otherwise in any way offering advice for or against any of the securities discussed - meet with a financial advisor for that information. Stocks and funds may not be good investments for you, depending on your financial situation.

We’re here for learning, not advice, and I wish you the best on your financial journey, and remember, tides fluctuate!