|Last week, the International Trade Commission (ITC) ruled against Arista Networks(ANET) in a patent dispute brought by Cisco Systems (CSCO).|
The ITC said Arista's products infringe on three Cisco patents. The companies face off again in August in a second round of patent infringement cases. In a last-ditch effort, Arista is asking the U.S. Patent and Trademark Office to invalidate a bunch of Cisco patents. It's unlikely either company will settle this dispute peacefully.
At the start of the year, I was bullish on the shares of Arista. I thought the company's attack from below would continue to take market share from Cisco and the stock would work higher.
Many tech bulls blew off the patent ruling, saying tech companies are frequently involved in patent fights and eventually cooler heads prevail and the companies reach a sensible settlement. And besides, many investors feel Arista is clever enough to get around Cisco's patents, since most of Arista's engineers designed the original Cisco products to begin with.
Maybe so, but I don't think it's going to be as easy as that. Because of the ruling, Arista is going to have to move production to the U.S. to avoid import restrictions.
The ITC ruling has entered the two-month presidential review process. Assuming the process expires without action, Arista will be banned from importing equipment towards the end of August. Arista has between now and August to build as much equipment as possible and get it into the U.S. before the end of August.
If Arista can come up with a workaround, the company will still need to get ITC and U.S. Customs approval to sell its equipment in the U.S. It could take months for customs to sign off on any workarounds. The U.S. accounts for 75% of Arista's sales.
Even if the ITC or U.S. Customs gives the company temporary approval to sell in the U.S., Cisco can still get a court order to stop the infringing sales.
Assuming Arista can get its equipment manufactured in the U.S., gross margins are going to take a big hit. In fiscal 2015, Arista reported gross margins of 65.3% and an operating margin of 28.2%. The switchover will cost them at least 50 basis points in gross margin (or more) and operating margins will probably be down nearly 200 basis points.
Tech investor's value top-line growth and this patent war could cost the company some growth as big customers take a wait-and-see approach to new purchases.
In fact, sales are already slowing. Sales were up 61% in 2014, slowed to 43% in 2015 and are estimated to be up just 28% this year. Right now, the consensus analyst estimate for fiscal 2017 is $1.26 billion in revenue, which would only be up 17% over 2016.
Likewise, earnings are slowing down, too. In 2014, on a non-GAAP basis, Arista earned $1.54, up 59%. But earnings are expected to be up just 13% this year and 11% next year.
The stock is down nearly 18% since the news of the patent infringement and import ban became public.
I would be very careful here. Over the last five years, it's been very difficult to make money in this stock, patent infringement or not. The stock could be good for a trade if it gets into the mid-$50s. Good news on the litigation front could bounce the shares higher, but it's hard to see the stock higher on an expanding top line. For now I would avoid shares of Arista.