Home Business Lakewood Capital Explains Arista Networks, Woolworths Limited Shorts

Lakewood Capital Explains Arista Networks, Woolworths Limited Shorts

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Lakewood Capital expected Arista Networks’ stock price to decline below $30 while Woolworths shares to fall by almost 50%

Lakewood Capital Management, an opportunistic, value-oriented investment firm headed by Anthony Bozza, disclosed some of its short positions including Arista Networks and Woolworths Limited, in a shareholder letter reviewed by ValueWalk.

According to the investment firm, Arista Networks and Woolworths Limited along with its other new positions have “attractive return potential.” It should be noted that the hedge fund disclosed the Arista short at the CSIMA Conference on Friday, as reported earlier by ValueWalk.

Lakewood Capital expects Arista shares to decline below $30

Arista Networks is a supplier of networking solutions. The company primarily sells network switches to the data center market. The company launched its initial public offering (IPO) on June 2014 and priced its stock for $43 per share.

During the 52-week range, Arista Networks traded as much as $94.84 per share and as low as $55 per share. The stock is currently trading $60.03 per share, down by more than 4% around 10:24 A.M. in New York.  The company has approximately $3.93 billion in market capitalization.

Lakewood Capital believed that Arista Networks is one of those technology component companies that were given a “remarkable valuation based on unsustainable first mover advantage.”

Lakewood Capital believes that Arista Networks will not be able to meet the market expectations. The investment firm said the stock will trade at “no more than 20x its longer-term GAAP earnings of $1.50 per share,” which is equivalent to a stock price below $30 per share—more than 50% lower than its current trading price.

Arista is facing escalating pressures

The investment firm noted that Arista Networks developed a Linux-based operating system combined with commodity to create a low-cost and low latency software-controlled switch for cloud networking architectures. The company is targeting the fast-growing end market with its leading product solution.

Arista Networks increased revenues from $72 million in 2010 to almost $600 million today. Lakewoood Capital emphasized that its heady growth attracted investors’ attention, but the investment firm believes that Arista Networks is poised to face a more challenging environment over the next quarters.

Lakewood Capital emphasize that Cisco Systems, the leading networking company worldwide launched a competing product, the Nexus 9000, which offers a nearly similar functionality at the same low price point. Cisco also started a price war, and it is bundling switches with other data center products, which makes it more competitive than Arista Networks.

In addition, Lakewood Capital believed that Arista Networks is also facing escalating pressures from other switch vendors such as Dell and Juniper Networks.  The company is also facing a lawsuit filed by its co-founder and 22% shareholder David Cheriton and another patent litigation filed by Cisco.

Specifically Bozza states:

In the fourth quarter, we initiated a short position in Arista Networks, which sells network switches, primarily into the data center market. Arista shares are up 50% since their June 2014 IPO and the company currently sports a $5 billion market capitalization, making it one of the most valuable networking component companies in the world. Much like InvenSense, a company we discussed in our last quarterly letter, we believe Arista is yet another case of a technology component company that has been awarded a remarkable valuation based on an unsustainable first mover advantage.

Several years ago, Arista developed a Linux-based operating system that it combined with commodity silicon to create a low cost and low latency software-controlled switch for cloud networking architectures. With a leading product solution targeting a fast growing end market, Arista has been able to increase revenues from $72 million in 2010 to nearly $600 million today. Such heady growth has unsurprisingly attracted attention, and we believe the environment for Arista will become significantly more challenging in the quarters ahead.

First, Cisco, the world’s leading networking company, has responded with the Nexus 9000 that delivers near identical functionality at the same low price point. In Cisco’s most recent earnings call, CEO John Chambers stated, “…in just one year we have blown by where [Arista] had gotten to in the whole history of their company.” In addition to improving their product, Cisco has initiated a price war and is bundling switches with its other data center products, and given its far greater scale, Cisco has a significant competitive advantage over Arista. Second, there is a troubling trend emerging for Arista as several key target customers are starting to buy commodity white box hardware and develop their own software. Large cloud players like Google, Amazon and Facebook have been leading this trend as white box hardware costs only 15% to 30% of the price of an Arista switch. Finally, legacy switch vendors like Juniper and Dell are starting to undercut Arista with their own software bundled with white box hardware. We believe all of these competitive forces will drive increased commoditization of Arista’s products, pressuring both their nearly 70% gross margins and impressive revenue growth that have attracted investor excitement.

In addition to these escalating pressures, a pair of ongoing lawsuits poses a significant threat to Arista’s future. Last spring, Arista cofounder and 22% shareholder David Cheriton resigned from the board and sued the company, claiming to own large portions of the software that Arista sells. Then, in early December, Cisco filed a lawsuit against Arista seeking an injunction from both the ITC and the courts for violation of 14 of its patents. Disturbingly, Cisco noted in its complaint that entire sections of its user manuals were being copied by Arista, complete with grammatical errors.

At a multiple of nearly 50x GAAP earnings versus peers at 13x earnings, Arista’s stock is unlikely to deliver on the market’s high expectations. Over time, we expect the stock to trade at no more than 20x our longer-term GAAP earnings estimate of $1.50 per share, equating to a stock price under $30 per share, more than 50% below the current price. If the company loses either of the ongoing lawsuits, the downside can be significantly greater. We imagine company insiders share our sentiment as the company recently released employees from the IPO lockup 21 days early.

Woolworths logo

Woolworths is an attractive short opporunity

On the other hand, Lakewood Capital finds Woolworth Limited, the largest super market chain operator in Australia and New Zealand an attractive short opportunity.

According to the investment firm the company is facing increasing competitive pressures from discounters such as Aldi and Costco particularly in the Australian supermarket industry.

Woolworths previously enjoyed a favorable competitive environment because the Australian supermarket industry historically operated as an effective duopoly—Woolworths and Coles account for more than 70% of the supermarket spend.

Over the past decade, Woolworths consistently delivered increasing profitability with an outstanding 76% return on capital in its Australian segment. Aldi, a German discounter noticed Woolworth’s impressive performance and established a presence in Australia.

Lakewood Capital believes that the Woolworths’ margins and returns on capital are no longer sustainable due to increasing competition.

Woolworths will be forced to cut prices

Lakewood Capital observed that the current dynamics of the Australian supermarket industry is close to its tipping point as German discounter Aldi continues to open 30 to 40 discount stores per year. At present, there are 366 Aldi stores in Australia.

Aside from Aldi, Woolworths is also facing competition from Costco and another German discounter, Lidl is also looking for locations in the country.  Lakewood Capital believes that Woolworths will be compelled to reduce its prices to remain competitive, which could lead earnings and margin pressure.

Lakewood Capital emphasized that Woolworths is an attractive short opportunity because of a combination of elevated margins, emerging competition and stretched valuation.

The investment firm expects the company to experience earnings pressure and multiple compressions as investors realize that it is not a defensive and steady growth story.

Lakewood Capital expected Woolworths shares to fall by nearly 50%

Lakewood Capital estimated that Woolworths’ operating margin will decline around 200bps if it will be force to cut prices by just a few percent in its Australian segments.

The investment firm also estimated the stock price of the company will decline almost 50%. Woolworths closed A$32.79 per share at the Australian Stock Exchange (ASX) on February 4.

Specifically, Bozza states:

Woolworths is Australia’s largest supermarket chain with operations across Australia and New Zealand. We initiated a short position in Woolworths last fall as we believe the company’s margins and returns on capital are unsustainable given growing competitive pressures from discounters such as Aldi and Costco.

We had spent some time over the past year analyzing the troubled U.K. supermarket industry, and we believe a similar dynamic is likely to unfold in Australia over the coming years. In the U.K., the existing grocery chains had for years enjoyed high margins and returns on capital that were ultimately attacked by discounters who gained significant market share by offering fewer products at significantly lower prices. Once the discounters reached critical mass, the incumbents began to experience declining store traffic and sales, resulting in significant margin pressures.

The Australian supermarket industry has historically operated as an effective duopoly with Woolworths and Coles accounting for over 70% of supermarket spend (the only other large player is IGA with less than 10% market share). This favorable competitive environment has allowed Woolworths to consistently increase its profitability over the past decade, resulting in the highest margins we can find for any major supermarket chain globally and a remarkable 76% return on capital in its Australian grocery segment.

However, these impressive economics attracted the attention of German discounter Aldi, which has now established a significant presence in the country. Aldi opened its first
store in 2001 and has grown steadily to 366 stores today. Aldi first focused on key markets along Australia’s eastern seaboard (which includes the key population centers of Sydney, Melbourne and Brisbane). At this point, Aldi has achieved critical mass in these markets with more than 10% market share and is now expanding its operations in other parts of Australia. With Aldi continuing to add 30 to 40 stores per year, we believe the industry is nearing a tipping point. When discounters in the U.K. (and France before that) reached similar market share levels, incumbents saw their operating margins fall by more than 300bps. In addition to Aldi, U.S.-based Costco currently has operations in Australia, and it has been widely reported that another German discounter, Lidl, has been scouting sites in the country. As Aldi continues to grow its store base and sales significantly faster than Woolworths and Coles (potentially joined by additional entrants), we believe Woolworths will be forced to cut prices to remain competitive, resulting in margin and earnings pressure.

Despite the risks that we believe exist for Woolworths, investors do not seem to share our concerns, with the stock trading at 8.5x EBITDA and 15x earnings. In our view, the combination of elevated margins, emerging competition and a stretched valuation make Woolworths an attractive short opportunity. Similar to what we saw unfold in the U.K. supermarket industry in recent years, we expect the company will experience both earnings pressure and multiple compression as investors realize that it is not the defensive, steady growth story they bargained for. If Woolworths were forced to reduce prices by just a few percent in the Australian segment to fend off competition, overall company operating margins would fall by roughly 200bps, which would translate into a decline in earnings of approximately 35%. We would expect investors to pay no more than 12.5x earnings for the business under such a scenario, resulting in almost 50% downside in the stock from the current price of A$31 per share.

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