Understanding the Income Statement of Arista Network

The company overview

Arista Networks, Inc. (ANET) engages in the business of developing, marketing, and selling cloud networking solutions. The firm cloud networking solutions consist of its Extensible Operating System (EOS), a set of network applications and its Gigabit Ethernet switching and routing platforms. The firm sells its products through both its direct sales force and its channel partners. Its end customers span a range of industries and include large Internet companies, service providers, financial services organizations, government agencies, media and entertainment companies, and other cloud service providers.

ANET is one of our top-rated ideas and the leader in AI-related companies selection. You can learn more about it here. Of course, given the current trend, the annual report, which was published just recently, practically begins with a description of the company’s role in the AI market:

The expansion of generative AI computing and distributed applications is further pushing the boundary of predictable scale and performance in the network. A common characteristic of these AI workloads is that they are both data and compute intensive. A typical AI workload involves large sparse matrix computations, distributed across hundreds or thousands of processors (CPU, GPU, TPU, etc.) with intense computations for a period of time and requires a high-bandwidth, scalable, lossless network in order to service these workloads. Arista’s AI strategy is based on achieving two key objectives. Arista first offers to customers the Arista Autonomous Virtual Assist using natural processing language to provide AI assisted outcomes for security and observability. Arista also provides network switching products intended to provide a robust interconnect that seamlessly links GPUs, compute and storage to deliver fast job completion time for training and generative AI workloads. An overview of our AI-enabled solutions is shown below:

Arista performance

In fact, the company’s shares were on our shortlist long before the trend on everything related to AI appeared — at the beginning of 2021. Since then, they have quadrupled, tripling quarterly revenue during and successfully completing a 1-to-4 stock split. In February, Arista Networks released another strong financial report, allowing us to recalculate their rating, which rose to an all-time high of 146%. Our rating is the sum of 4 scores, each of which is assumed to be 25% for an ideal company for investing.

One of the estimates is historical financial performance (profitability), which we calculate by analyzing the income statement figures. We decided that the record rating and Arista Networks new report are an excellent opportunity not only to talk about the company’s successes but also to show, using its example, how we analyze the income statements.

Going for gross margin

Let’s hit the road from the starting line for every income statement — revenue. Revenue is the total amount of money the company receives from selling its goods and services. This is a fairly simple and basic value. Sometimes companies disclose what the revenue consists of: how much was for the sale of services, how much for services, if this is relevant to the company’s business, as in the case of Arista. Another basic concept is the cost of goods sold or the cost of revenue. This line includes any direct costs items that a business incurs in the manufacture, purchase and sale or resale of products. Subtracting costs from revenue we get a very important measurement that is called gross profit. This line stands for how much the company makes from its business after incurring basic production costs. Finally, we have reached the first key metric of the financial performance of a business, which we use in calculating a company’s rating — gross margin. You can calculate it yourself by dividing gross profit by revenue, or you can find it on Form 10-K in the management`s discussion and analysis of financial condition and results of operation section

Gross margin is the proportion of revenue that a company retains after the costs incurred to produce marketable goods and services. The higher this value, the more the company can save on production costs, therefore, the more opportunities it has to scale up a profitable business. We use 40% as the benchmark to compare the company`s value to understand that the business performs really well.

Calculating operating margin

But gross profit does not include expenses such as research and development (R&D), sales and marketing as well as general and administrative expenses. They come next. These costs have nothing to do with the production of goods and services right now, but they affect how those goods can be produced in the future and how they will be delivered to consumers. Arista reveals these costs in more detail in its report:
—Research and development expenses consist primarily of personnel costs, prototype expenses, third-party engineering costs, and an allocated portion of facility and IT costs. Our research and development efforts are focused on new product development and maintaining and developing additional functionality for our existing products, including new releases and upgrades to our software and applications;
—Sales and marketing expenses consist primarily of personnel costs, marketing, trade shows, and other promotional activities, and an allocated portion of facility and IT costs.
—General and administrative expenses consist primarily of personnel costs and professional services costs for our finance, human resources, legal and certain executive functions. Our professional services costs are primarily related to external legal, accounting, and tax services.

Therefore, all these expenses are called operating expenses and when we subtract their sum from the gross profit, we get the operating profit or income from operations. In a recent letter to shareholders of Berkshire Hathaway Warren Buffett called this metric the most important for assessing business performance. The operating income figure allows us to obtain the second key metric of financial performance from the income statement — operating margin — by dividing income from operation profit by revenue. Operating margin is the percentage of revenue a company retains after incurred production and operating costs, but before paying interest and taxes.

Arista’s operating margin is almost 40%, which means that out of one dollar of revenue, 40 cents remain after all the costs incurred for services production and selling. This is a very high level meaning very high operational efficiency of the business. By comparison, the same figure for Buffett’s Berkshire empire is only 13%.

Reaching net profit margin

After all the costs of creating goods and services have been incurred, as well as the personnel and marketing costs, the company will have to incur financial expenses. they consist of expenses for taxes and debt service or otherwise interest expenses. Sometimes a business can receive a tax benefit, and then the tax expense will become positive and increase the company’s profits. However, it often happens that taxes reduce the financial result of a company. So are interest expenses. However, in the case of Arista, we see that the line for financial costs is completely absent. Why? Arista simply has no debts. Brilliant.

The report also often includes the line of other income, which can be either positive or negative depending on the business. As a rule, this article contains various types of revaluations: assets, real estate, currency, and all expenses that need to be reflected but cannot be classified as production or operating. What does the Arista report say about this?

Other income consists primarily of interest income from our cash, cash equivalents and marketable securities, gains and losses on our marketable securities and strategic investments, and foreign currency transaction gains and losses. The favorable movement in other income during the year ended December 31, 2023 as compared to 2022 was driven by an increase in interest income of $124.9 million due to an increase in our cash and investments balances and higher interest rates.

And finally we got to net profit (net income). Net profit is the amount of money that remains at the disposal of the company after deducting production and operating expenses, as well as taxes and other obligatory payments. What do we get if we divide net profit by revenue? We get net profit margin which is the third key metric of income statement analysis. Net profit margin is the proportion of revenue a company retains after taking into account ALL costs incurred. The 20% threshold in our valuation model separates outstanding companies by this indicator from all others. The more revenue remains in the form of net profit to shareholders, the greater the competitive advantage the company has!

Earnings per share

A mandatory attribute of a good income statement for a public company is the presence of the number of shares outstanding, which is necessary to calculate earnings per share. It is important to pay attention specifically to diluted earnings per share since it is a performance metric used to assess a company’s earnings per share if all convertible securities were exercised or in other words, this is a profit closer to the real things.

By analyzing the dynamics of this indicator, we assess the sustainability of the company’s development. Two ratios responsible for this can be found in the Stability section of company card.

Additional metrics

Interest Coverage Ratio can be calculated by dividing operating income by interest expense. It can be interpreted as the ability to pay the interest on its debt, such as loans payable and bonds payable. However, for Arista this indicator is irrelevant due to the lack of debt.

Price-to-Earnings (P/E) Ratio is the ratio of the share price and the profit due to it. This indicator tells you how much the entire company is worth on the market today, if the price is measured by annual net income. An extremely important ratio for dynamic analysis in our valuation of the company.

Arista Networks rating

Although Warren Buffett has great respect for operating efficiency, we do not use operating margin in assessing a company’s financial perfomance. Of the listed key metrics, our evaluation system includes only gross and net profit margin, since they allow us to evaluate the business at the initial stage of production and at the final stage. We believe this is sufficient to answer the question of whether a company has a strong advantage in technology, business model or market position to outperform the competitors. However, to these two metrics we have added one more mixed one. It is the ratio of cash flow from operating activities to net income (earnings quality). Don’t forget that the income statement is an accounting document. And it does not reflect the actual flows of funds that occur in the company’s accounts. That`s why we use the data form Cash Flow Statements as well to check the financial performance of the company. In order for good earnings report numbers to translate into a high rating, we need to make sure the company’s earnings are of high quality.

Arista has a profitability score of 32%, while we mean that an ideal company to invest in has a rating of 100%, made up in equal parts of 4 blocks, one of which is profitability. Therefore, we can conclude that Arista outperfomes the benchmark by 7%. Invest wisely.