A consideration of Arista

Investment Analysis Clubs Saul’s Investing Discussions
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I’m really torn about what to do about Arista (ANET). Here’s a little discussion I had with David K (TMF Pencils) who is very positive about them, on the Arista board. David gave a very nice update on the quarterly earnings and the lawsuit picture, but tended to minimize the danger from the lawsuit, saying “And the lawsuit hasn’t dented Arista’s ability to bring new customers on board.” and giving the following quote from the CEO as proof:

“In terms of the lawsuit, initially we had customers coming to me that they understand that this is because of our success. Literally, quotes from different folks like, “If they can’t innovate, they litigate.” So no question that they want us to continue to innovate and indemnify their contracts but, frankly, the investors are more worried about it than our customers.”

I responded:

“David, they slipped this one past you: So no question that they want us to continue to innovate and indemnify their contracts

That means the customers are putting into every contract that if Arista loses the lawsuit, they have to compensate each of these customers for any loss or inconvenience. I assume this means even if they have to take out the Arista system, which could be VERY expensive.”

Here’s my dictionary definition of indemnify:

compensate (someone) for harm or loss: the amount of insurance that may be carried to indemnify the owner in the event of a loss.
• secure (someone) against legal responsibility for their actions:

I pointed out that Arista could have a lot of losses if they lose the suit.

He responded: To be clear, I don’t mean to imply that the lawsuits aren’t a risk for Arista investors. They absolutely are a risk and could (as you point out) turn out to be very costly for Arista if the company is found to be in the wrong. Thankfully the company does have a hefty and growing cash pile which could absorb short-term legal settlement costs.

The bigger long-term risk, in my mind, is if Arista is no longer able to sell its products/services in their current form if Cisco and/or Optumsoft come out ahead in the lawsuits. I’m less worried about short-term cash costs and more concerned about Arista’s ability to innovate and compete over the long haul. The lawsuits could dent the product differentiation Arista currently offers with its networking solutions.

I responded as follows:

“David, It’s very hard to see how Cisco could completely lose the lawsuit. After all, all these guys worked out the system that Arista is using while they were all working at Cisco! In addition, the fact that Arista copied the Cisco manuals probably isn’t a case winner in itself, but it will sure look bad and influence a jury. The real question is what will Cisco win? If it’s just a lot of money, and that Arista has to pay a license fee, they can probably survive that without much problem, but if they can no longer use the system they are currently using, that would be a VERY big deal. We won’t know until 2016, but there are plenty of RB stocks that don’t have potential business-breaking lawsuits in progress.”

He responded that he doesn’t feel that Cisco winning is a done deal, and pointed out that he’s suspicious about the timing ot the Cisco suit, etc, and that the Arista insiders have a lot of stock, and good lawyers.

So you can see there’s plenty of room for very differnet views, and I’m wondering if I should take a tiny position to keep it on my radar screen, or just forget about it. I really don’t like companies with major problems, as there are plenty around that don’t have them.

What are your thoughts?

Saul

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What are your thoughts?

Hi Saul,

One of my early Silicon Valley companies had a significant connection with one of the key Arista founders back in the day, and I have tremendous respect for him – he is brilliant, hard-working, and serially successful,

That said, I would not even consider investing in Arista due to the lawsuit. All of your observations are spot-on (and I speak as an attorney who worked in this industry with players of this level for decades).

Arista offers a mix of potential high returns and potential mortal risks. Your portfolio is loaded with companies that offer similar upside and far less downside risk. Why stretch to add Arista? Unlike the paid MF services, you do not need to keep coming up with new ideas – you can afford to use a much more careful filter.

If I had to guess, I would say that your spectacular success as an investor has come from applying a ruthless filter to potential (and even existing) investments. As a result, your investing dollars are concentrated in a few “best ideas.”

This is very different than, e.g., Anurag’s model – which apparently works equally well for him. Even with Anurag, though, I think he has a de facto ruthless filter, in the sense that he does not put new money in ideas that are not succeeding well.

I would not presume to give you investing advice – I have done OK at generating income, but quite poorly at investing that income. (Thank heaven for MF Pro, the outstanding returns from which have sufficiently compensated for my self-directed investing fiascoes to allow me to meet my overall portfolio target of 2%/year returns!)

In contrast, you seem to have a rare knack for investing. So it feels a bit strange to be suggesting investing thoughts to you.

But you asked . . . .

Rich

CED (also ADD)

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Thanks Rich, that’s incredibly helpful advice, especially coming from an attorney in the field.

Saul

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Saul,

In his post http://discussion.fool.com/1069/hi-all-i-am-not-an-expert-in-pat… TradeDuck makes a rather persuasive case for the lawsuit being very consequential. Since you post to the same board, I expect you have read his post, but others may benefit from the following. Two of his source references pertaining to the lawsuit:
http://www.businessinsider.com/cisco-sues-arista-networks-20…
http://finance.yahoo.com/news/cisco-just-fired-another-shot-…
Among the points: Cisco General Counsel indicated Cisco rarely sues a competitor, making the point that Cisco would not sue without a very strong case. Arista got caught with Cisco manuals, Arista was formed by former Cisco employees immediately after leaving Cisco, Arista has many former Cisco employees, Cisco claims twelve patent infringements, so it is not much of a stretch that Cisco discovery will reveal other elements of the Arista products belong to Cisco. Cisco has much deeper pockets than Arista.

To your question of “what are your thoughts”:
-Cisco would certainly love to knock Arista out of the picture and this lawsuit could well cripple or destroy Arista. The lawsuit will likely take about two years, two years of shadow over ANET stock.
-Since Arista’s standard Master Purchase Agreement apparently includes indemnification of their customers (ANET investor relations to TMFPencils), customers can continue to migrate to Arista’s superior product without too much risk. The risk will be assumed by Arista’s insurance companies and investors.
-While granting that Arista has an excellent product, strong earnings pattern, and a growing customer base that would otherwise justify investing in ANET, there are plenty of good companies in which to invest without the risk of a potentially company exploding lawsuit. I will look to other companies.

Drake54

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I am okay sitting this one out.

Sure, it may overcome the litigation issues, but I don’t like to risk/reward trade off…

Let this one go…there are so many other fishes in the sea…lol…

or you could use that money you were planning to buy ANET and buy more
BOFI or SWKS…which just have as much promise in growth as ANET…

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Thanks Darrell and Drake. I think I’ll watch from a distance too.

Saul

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Saul,

I think you have already answered your question in your post:

“I really don’t like companies with major problems, as there are plenty around that don’t have them.”

You are the master of your investing style. Why make an exception? Plus you already have such a great set of companies that you don’t need to venture out into an unknown territory. Leave the “torn about” sentiment for the rest of us :).

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Allow me the opportunity to offer a different point of view: I’m not that particularly troubled by the overhang from the lawsuit.

It’s not that I think CSCO’s lawsuit has no merit. To the contrary, I think CSCO may very well have a solid case for patent infringement. Moving on…litigation such as this typically isn’t resolved for many years. The question uppermost in my mind is whether or not the litigation overhang will significantly curb sales. At present, it doesn’t seem to have had much affect.

Here’s why I invested in ANET: Everyone is all aflutter about the massive potential of the “Internet of Things” (IOT). I get it. I do believe the demands on existing communication networks will grow exponentially for years to come. Ergo, I wished to invest in a firm serving the network operating systems market niche. ANET offers a highly competitive product. CSCO doesn’t like it. I get that, too.

My investment thesis is simple: ANET, at present, has a great opportunity to increase sales/revenue dramatically in the coming years. Meanwhile, the litigation will proceed at a relatively glacial pace, without much effect on economic realities.

At some point, there will be a verdict. I’ve lived through a boatload of “patent wars” from the mortal combat waged between Qualcomm and Nokia, the antitrust case against Microsoft, the never-ending disputes between Apple and Samsung and, of course, the countless legals battles between CREE and its competitors. Given all that litigation, one might conclude that the stakes must be quite high. They weren’t. The solutions typically ranged from mild marketing tweaks, cross-licensing agreements, token reparations or some pointless verdict, given that the products/services in dispute had already become obsolete.

I’d certainly be happier if there were no lawsuits. But, in the grand scheme of things, ANET will either thrive over the course of the next few years because of the strength of its products/services or it will fade from contention. The lawsuit won’t be a major factor in that dynamic.

I remain long ANET.

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